Contents Acknowledgments Preface Chapter 1: Democracies’ Fatal Attraction of Populism Default, an Expanded Definition Debt Default in History—A Recurring Theme Nobody Likes a Lender Populism, Democracy, and the Road to Default The Demographics Are Awful The Special Roles of the United States Universal Suffrage—The Holy Grail or the Villain? Universal Suffrage—The American Story Rational Economic Man? Irrational Voters? Is a Meritocracy Good for Everyone? Do We Want a Meritocracy? Public-Sector Unions—We Vote for You, You Reward Us Debt and Macroeconomics Hyman Minsky: Another View of Debt and Macroeconomics Culture Counts One Note of Optimism Chapter 2: The Sorry Fiscal State of the Advanced Countries Sovereign Debt/GDP Outlook for the United States Dismal Demographics Race and Ethnicity—An American Complication Unfunded Entitlements and Dismal Accounting And Then There Are the American States The Ownership of US Government Securities If Something Cannot Go on Forever, Then It Will Stop Europe—The Default Process Has Already Begun The Euro—What Should Have Been The United Kingdom—Not a Euro Country Japan—The Enigma Chapter 3: A Diversion to India and China India—The Democratic Surprise China—Not a Democracy, Populism Less of a Problem Chapter 4: The International Monetary System—In Desperate Need of Repair Let’s Start with History and Economics The Gold Standard in Theory—The Price-Specie Flow Mechanism The Sad Evolution of the International Monetary System The International Monetary System Must Change—But to What? Chapter 5: The Road to Worthless Paper Money China—The Birthplace of (Worthless) Paper Money A Persian Diversion The American Story—“Honest Abe” Prints Some Money German Hyperinflation—Is This the Prototype? Modern Inflation Are We Really in Deflation? Measuring Inflation—Are the Numbers Really Higher? Chapter 6: An Overall Assessment of the Current Investing Scene The Bad News The Good News and Some Long-Term Trends (Which Are Mostly Good News) The Unknowns Supply-Side Reforms Must be Enacted Taxation—Americans versus Everybody Else Chapter 7: Investment Survival in the Age of Defaults Asset Classes for Investment Survival Fixed-Income Securities European Equities What about American TIPS? Gold—Don’t Get Carried Away Commodities/Resources—Not a Simple Story Selected Big-Cap Nonfinancial, Global Companies Large Global Banks—Avoid Equities from Selected Emerging Markets Appendix A: A Quantitative Approach to Sovereign Risk Assessment About the Author About the Contributor Index Copyright © 2013 by John Wiley & Sons Singapore Pte Ltd Published by John Wiley & Sons Singapore Pte Ltd Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center Requests for permission should be addressed to the Publisher, John Wiley & Sons Singapore Pte Ltd., Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628, tel: 65–6643–8000, fax: 65–6643–8008, e-mail: enquiry@wiley.com Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor the author shall be liable for any damages arising herefrom Other Wiley Editorial Offices John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United Kingdom John Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, Canada John Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany ISBN 978-1-118-24721-1 (Cloth) ISBN 978-1-118-24724-2 (ePDF) ISBN 978-1-118-24723-5 (Mobi) ISBN 978-1-118-24722-8 (ePub) I would like to dedicate this book to my late mother, Dorothy Treadway, who always supported and encouraged me in the world of learning and intellect Acknowledgments I would like to express my appreciation to my colleague Dr Michael Wong, who encouraged me to write this book and who provided research assistance I would also like to thank Rudy Beutell of Scarsdale Equities LLC for his invitations to his firm’s regular lunches These lunches, attended by fund managers as well as economists and strategists, gave me the opportunity to exchange ideas with investment practitioners Preface Why Another Book on the Financial Crisis? A mass of sovereign defaults, broadly defined, is looming on the horizon as the global financial crisis that began in 2008 lumbers on The primary objective of this book is to come up with some answers for investors who, by and large, will be the ones defaulted on Worse than that, governments desperate for money will look to the so-called “rich” and the more advanced in age, aka the investor class, to plug the yawning gaps in government budgets In all countries affluent elders will be pitted against their or somebody else’s children In some countries, affluent investors from “elite” racial groups or castes will be pitted against different and allegedly downtrodden castes or racial groups The reelection of Barack Obama and Democratic control of the Senate will accentuate this process in the United States A simple observation was the spark that created the incentive to write this book Today the world’s richest, best educated, most democratic—can we say most civilized—countries are headed for bankruptcy and default Nobody is surprised when poor countries with their imperfect institutions, corrupt leaders, and low levels of education go bankrupt But the rich, advanced countries? This was not supposed to happen This observation immediately raised two questions, which this book will try to answer One, how did this happen? And two, how can investors preserve their wealth through the chaos ahead? The terrible experience of German fixed-income investors in the early 1920s was deep in my mind These investors constituted the solid bourgeois rock upon which German society rested They were wiped out, and we know the history The 1920s were followed by the 1930s, with the Great Depression and rise of Adolf Hitler In the case of Germany, from 1914 on it was one black swan after another—that is, an unexpected event with a profound impact This book is written for both institutional investors and for private investors who think they are affluent today but must live off their investments Investing is never easy, but in times of historically unprecedented and unpredictable cataclysmic shifts in the economic landscape, investing comes close to being mission impossible Nevertheless, investors have no choice They must try Every private investor today must harbor a fear in his or her heart that some terrible shift will occur—call it a black swan or whatever you like—that will reduce his or her real net worth to zero For younger people, these shifts can be opportunities But for older, retired, or semiretired people for whom investment income may be their only income and for whom starting over to take advantage of new opportunities is not an option, this can be a death sentence For institutional investors, the penalty for failure to see the shifts coming is simply that they lose their jobs That may be incentive enough Overview of Contents Chapter takes on the question of why the advanced, civilized countries are on the way to being broke and in default The answer given is that in democracies there is an inexorable tendency toward populism by which the electorate attempts to make an end run around what the free market would provide and votes for politicians who provide the electorate with benefits, entitlements, and socialized risk All these accumulate over time and become ultimately unaffordable In other words, it is democracy itself that harbors this fatal predisposition to fiscal profligacy As a part of this process, Classical Gold Standard See also Gold standard Clean slates Clinton, Bill Commodities/resources Common stocks Community Reinvestment Act (CRA) Companies, global Confucian societies/values See also specific countries Constitution (US) Consumer sector stocks Continental (paper currency) CRA (Community Reinvestment Act) Credit default swap (CDS) Credit rating agencies: practices of replicating models of CTRISKS (credit ratings agency) Cultural values See also specific countries Datz, Werner Debt: central versus general forgiveness of gross versus net increase in liabilities versus macroeconomics and Debt: The First 5000 Years (Graeber) Default: benign defined history of by inflation types of United States Defined benefit pension plans Defined contribution pension plans Deflation Demand management Democracy: demand management in economic approaches in fiscal consequences of income, redistribution of republic versus risk, socialization of Demographics: about China Europe United States Dimon, Jamie Disinflation Dodd, Christopher Dodd-Frank bill Dollar: Hong Kong Singapore United States Dubai East Asian economic model ECB (European Central Bank) Economic approaches Economic forecasts Economic model, East Asian Economic structure: China Hong Kong Japan Singapore Switzerland United Kingdom Efficient market hypothesis (EMH) Elections of 2012 (US) Emerging markets See also specific countries about Brazil China equities globalization and India Russia South Africa technology and variations among volatility in EMH (efficient market hypothesis) Energy Entitlement liabilities, unfunded Equities See also Stocks Brazil China emerging market Europe India Russia South Africa Ethnicity See Race and ethnicity Euro: about advantages of bailouts and bank clearing mechanism banking system integration, lack of critics of gold standard versus investment in market mistrust and models for problems with as reserve currency socialism and Europe See also Euro; specific countries anti-supply-side economics banking system integration, lack of default process demographics equities fiscal union attempts future scenarios gold standard social democratic model European Central Bank (ECB) Exports from China Fannie Mae: about accounting issues CEOs credit quality standards growth of investment in low-income lending origin of quotes on role of Federal government expansion (US) Federal Home Loan Mortgage Association See Freddie Mac Federal National Mortgage Association See Fannie Mae Federal Reserve (US) Federal spending (US) Fiat paper money: about China deflation disinflation Germany inflation, measuring inflation, modern international monetary system history Persia trusting, reasons for United States Fiat Paper Money: The History and Evolution of Our Currency (Foster) Financial instability hypothesis (FIH) Financial repression Fixed-income securities Food Forecasts, economic Foreign financing of government (US) Forgiveness of debts Foster, Ralph T Founding Fathers (US) Franc, Swiss France: emigration from politics Frank, Barney Franklin, Benjamin Freddie Mac: about accounting issues credit quality standards growth of investment in origin of quotes on Friedman, Milton Fuller, Ida May Future scenarios See also Asset classes about bad news good news and long-term trends supply-side/structural reforms taxation unknowns General debt General government gross debt/GDP See Sovereign debt/GDP Genetically modified food Germany: energy policy fiat paper money fiscal union attempts hyperinflation information, lack of Globalization Gold See also Gold standard as alternative asset as asset class German hyperinflation and India as inflation hedge as investment if gold standard is restored restrictions on holding Gold exchange standard Gold standard: about Bryan, William Jennings, on capital flows and central banks and conclusions about Europe international monetary system history restoration of theory underlying United Kingdom United States wars and Government expenditure/GDP Government Investment Corporation (Singapore) Government signals Graeber, David Grand Illusion, The (Angel) Great Recession Greece Greenspan, Alan Gross debt “Growth decree” (Italy) Hayek, Frederick von Heritage Foundation Hispanics Historical volatilities Hollande, Francois Hong Kong: dollar, future of economic structure as financial center France, immigrants from inflation investment strategy politics and history Real Estate Investment Trusts (REITs) statistics Housing bubble Hudson, Michael Hume, David Hunter, Oakley Hyperinflation IMF See International Monetary Fund (IMF) Income: inequality of redistribution of tax on India: caste system Chettiars as money lenders companies economic status equities future scenarios gold history of property rights religion statistics subsidy programs trade Indian Union Indicators: major market Inflation: banks and default by Hong Kong hyperinflation measuring modern purchasing power and Singapore United Kingdom statistics for pensions International Monetary Fund (IMF): defaults on troubled loans economic forecasts sovereign debt/GDP statistics International monetary system alternatives: characteristics of successful system gold standard, restoration of Keynes’s bancor private moneys, alternative rules, setting up International monetary system history: about bimetallic/silver standards pre-1879 Bretton Woods system Classical Gold Standard current dollar-centric fiat money system gold exchange standard quantitative easing World War I fiat money period Italy Japan: economic structure taxation yen as investment Jews as money lenders Johnson, Samuel J.P Morgan (company) Jubilee, as term Keynes, John Maynard Kotkin, Joel Kurzweil, Ray Labor restrictions/regulations Laffer curve Lagarde, Christine Law of Accelerating Returns Lee Kwan Yew Lehman Brothers Lenders, dislike of Leviticus (Old Testament book) Liabilities: debt versus unfunded entitlement Lincoln, Abraham Long-Term Refinancing Operation (LTRO) Maastricht Treaty MacDonald, Ramsey Macroeconomics Madison, James Malaysia Market indicators on sovereign risk: credit default swap historical volatilities shadow models and volatility indexes Market mistrust Market signals Maxwell, David McNutt, Alexander G Medicaid See Unfunded entitlement liabilities Medicare See also Unfunded entitlement liabilities Meritocracy Merkel, Angela Mesopotamia, ancient Migration Minsky, Hyman Mohanty, M S Money See also Fiat paper money; specific currencies alternative banks and history of quantity theory of Monti, Mario Moody’s Morgan, J P Mortgage crisis Net debt Nixon, Richard Obama administration See also United States energy policy federal government expansion fiscal policy regulations student loans tax increases on dividends and capital gains Obamacare See Unfunded entitlement liabilities Occupy Wall Street Organic food Organisation for Economic Co-operation and Development (OECD) Panama Panic of 1907 Panic sentiment Pareto efficiency Pension plans People’s Action Party (Singapore) People’s Liberation Army (PLA) Persia Politics and history: France Hong Kong Singapore Switzerland Populism, defined Pound, British Price-specie flow mechanism Prince, Chuck Private moneys, alternative Private pension plans Private-sector unions Progress Property rights: India United States Public-sector pension plans Public-sector unions Purchasing power: deflation and inflation and Puritan ethic Quantitative easing Quantitative models on sovereign risk: dependent variables independent variables, debt-related independent variables, other studies with bond spreads, ratings or crisis as dependent variable Quantity theory of money Race and ethnicity: Brazil Singapore South Africa United States Rationality Real estate: China German hyperinflation and Washington, DC Real Estate Investment Trusts (REITs): Hong Kong Singapore Redistribution of income Reforms, supply-side/structural Regulation Q Reichsbank Reinhart, Carmen REITs See Real Estate Investment Trusts (REITs) Republic Ricardian equivalence Risk See also Sovereign risk curtailing socialization of Rogoff, Kenneth Romney, Mitt Roosevelt, Franklin D Rothschilds Russia Sands, Peter Schneider Electric Schumer, Charles Securities, fixed-income Serial defaulters Shadow models of sovereign risk Silver, restrictions on holding Singapore: bank shares culture dollar economic structure education industries inflation investment suggestions languages politics and history race relations Real Estate Investment Trusts (REITs) retirement scheme smallness of sovereign debt/GDP statistics Switzerland, similarities with Slim, Carlos Smith, Adam Smith, Iain Duncan Social democratic model Socialism Socialization of risk Social Security See also Unfunded entitlement liabilities South Africa South Korea Sovereign debt/GDP: about China Singapore Sovereign risk: about banking system stability and banks, assessment and management by capital flows and credit rating agencies, practices of credit rating agencies, replicating models of definitions of managing market indicators on measuring quantitative models shadow models unpredictability of Standard Chartered Standard & Poor’s (S&P) State pension plans Statistics: Australia Canada China Hong Kong India Singapore Switzerland Stocks See also Equities agricultural China common consumer sector Student loans Suffrage, universal Supply-side/structural reforms Swiss franc Swiss National Bank Switzerland: economic structure franc politics and history quantitative easing Singapore, similarities with statistics TARGET (Trans-European Automated Real-time Gross Settlement Express Transfer System 2) Taxation: future scenarios Japan United States Technology: development of emerging markets and exposure to progress in Temasek Thailand Thatcher, Margaret This Time Is Different: Eight Centuries of Financial Folly (Reinhart and Rogoff) TIPS (Treasury Inflation Protected Securities) Tocqueville, Alexis de Trans-European Automated Real-time Gross Settlement Express Transfer System (TARGET 2) Treasury Inflation Protected Securities (TIPS) Unfunded entitlement liabilities Unions United Kingdom: economic structure gold standard inflation statistics for pensions pound United States See also specific agencies and programs accounting practices by federal government banking laws and regulations budget deficit Civil War Constitution default history demographics dollar elections of 2012 energy policy Federal Reserve federal spending fiat paper money foreign financing of government foreign relations Founding Fathers future scenarios gold, restrictions on holding gold standard government securities, ownership of income tax inflation, measuring outlook for pension plans, state property rights race and ethnicity silver, restrictions on holding suffrage, universal taxation technology development unfunded entitlement liabilities War of Independence wars, financing Universal suffrage Values, cultural VIX (volatility index) Volatility: of emerging market equities historical indexes of Volker rule Wall Street Reform and Consumer Protection Act Wars, financing: China gold standard and United States Washington, DC Wealth of Nations, The (Smith) World War I fiat money period Wriston, Walter Yen, Japanese Zampolli, Fabrizio ... particularly in the entitlements areas but also on sovereign debts—may be part of the reform process Chapter gets to the theme raised by the title of the book investing in an age of sovereign defaults... bring with them over time a rising sense of entitlements The issue of the less-affluent voting to take wealth and income of the affluent was very much on the minds of America’s founding fathers James... capabilities Then came the Depression and deposit insurance After that came the end of the Bretton Woods system in 1973, which got rid of the restraining influence of gold and set the world on the path of