In a book as riveting as today’s headlines, you will learn how the financial crisis started, what will likely happen next, and how you can survive and prosper through these dangerous days.
John Nyaradi: I’m John Nyaradi, publisher of Wall Street Sector Selector. Today, I’m really pleased to welcome our special guest, Peter Tanous, co-author of Debt, Deficits and the Demise of the American Economy. Peter, welcome to Wall Street Sector Selector.
Peter Tanous: Thanks, John, a pleasure to be with you.
John Nyaradi: Peter is president of Lepercq Lynx Investment Advisory, a firm with more than $1 billion under management for both individuals and institutions. He has 40 years of experience as a financial professional and he’s author of “Investment Gurus” and “The Wealth Equation,” both selections of The Money Book Club.
Peter wrote Debts, Deficits, and the Demise of the American Economy with co-author Jeff Cox, a staff writer with CNBC. Their book reads like today’s headlines and is truly an extraordinary achievement. Peter, let’s start where it all begins, the “PIIGS,” where they are and what you see happening next.
Peter Tanous: Sure. With pleasure, John, and thanks for your comment about the book. My co-author, Jeff Cox, and I tried very hard to make this a linear progression of events, not some outrageous claims of, you know, the world is coming to an end or doom and gloom. What we tried to do is follow what we refer to as epistemic humility, meaning that the points we make and the projections we make are linear events, which are the only things you can really predict.
So, let’s start with Greece. If you take a linear event of where Greece stands in terms of its debt and where it’s going, there is simply no alternative to a default. The fact is that Greece cannot get out of its mess without restructuring its debt. So why isn’t everybody focusing on that rather than these rescue plans that ultimately will lead to the same conclusion — restructuring?
And the reason I think is this; the real problem is that we don’t know what the consequence of a major country defaulting is going to be. Think of the following possibilities and they’re not good. One is what they refer to as contagion. If Greece is allowed to default, what happens to Ireland, what happens to Portugal, and then worst case, Spain? Spain is the tenth largest economy in the world. If Spain goes, you have an extraordinary crisis. So they’re trying first and foremost to stop contagion because we don’t know where it leads.
John Nyaradi: Let’s move closer to home now, the United States.
Peter Tanous: Sure. The problem here is, and this will come as no surprise, our huge debt and our mounting debt and our growing debt that at some point breaks. We’re at the breaking point now, and unfortunately, we have a very polarised Congress that is sticking to political positions rather than trying to solve the problem. And this is not a question of picking sides, I don’t pick sides, I think both sides are to blame, but here is the issue.
Politicians need to stop acting like politicians and start acting like statesmen because that’s what it’s going to take to solve this crisis. You’re going to have to have compromise on both sides. We must show the world that we are prepared to get our balance sheet in order as a nation. It will require some revenue increases. It will require an awful lot of cuts and these are things that politicians are loathe to do.
But here’s the really scary part about where we are today and I want to put this in a context that we can all understand and maybe most of us will agree with. The Fed, through its quantitative easing programs, has been buying the majority of the Treasuries, securities issued by the United States Treasury, and in so doing, has been driving interest rates down, OK. Does it not seem surprising that American interest rates are at an all-time low at a time when our debt situation is at an all time high? Our debt situation is terrible, it’s the cause of the current crisis and yet interest rates are at an all time low, go figure.
Well then take a look at gold. Isn’t it surprising that while interest rates are at an all time low, gold is at an all time high? Well, maybe it’s not so surprising because people who are buying gold today are basically betting that the United States will not be able to keep interest rates artificially low with the huge amount of money that has been printed and created by the Fed and sitting in the banks and on the Fed’s balance sheet. One day that money is going to come out and I would remind everybody of Milton Friedman’s, perhaps America’s greatest economist, most famous statement, “inflation is forever and at all times a monetary phenomenon.” Well, the Fed just increased its balance sheet by $2-1/2 trillion and that money has to go somewhere.
Inflation has been around a long time. But the peculiarity, John, of today’s situation is the fact that the Fed has been driving interest rates artificially low. Now the motive to do so is very clear, we are in a terrible economic slowdown and low interest rates are needed to induce entrepreneurs to borrow and create businesses and create jobs.
The sad fact of today is that we have a very high unemployment rate and it is very difficult to see how that unemployment rate comes down anytime soon and I mean within years. This is a tragedy. The US GDP is growing at an alarmingly slow rate. We are growing at around 2%. You cannot get unemployment down if we’re only growing at 2% and this is a factor that needs to be addressed and is as important as anything else.
John Nyaradi: In your book, you mention this linear progression towards a possible stock market crash.
Peter Tanous: Predicting stock market crashes is, I think, kind of silly even though we mentioned that there’s the possibility. The way I want to leave this is to say that there is a possibility of a stock market crash, and I’m not going to predict the timing because I wouldn’t know where to begin. But put another way, I think the only time Congress is going to get serious about solving the problems is when we have the equivalent of a financial 9/11.
We’re going to have to have the financial equivalent of planes hitting the World Trade centre for them to get serious and that’s shocking and it’s a tragedy, but I think that’s the only way we’re going to get there.
John Nyaradi: Let’s talk about solutions.
Peter Tanous: We have chapters about how to invest for these bad times that we see ahead of us. And I think that’s one of the benefits that the book offers to a reader who is not only interested in the problem, but interested in a solution for him or her. We have chapters on gold and oil and other ways to allocate portfolios today that are very different from the way we would have done it in the ’90s.
On the Federal level, we need to raise revenues, we need to cut expenses; easy to say, hard to do. On the revenue side, one of the things that we will need to consider is the equivalent of a national sales tax, but I think the value added tax model is a better model. As you know, almost every European country has a value added tax and what that does is it taxes goods at different levels of production. For example, if you buy raw material and you make a tire, there’s a tax when it becomes a tire. When you put the tire on a car, there’s another tax as it becomes a car. So it’s progressive and it raises a lot of money.
Will it increase prices? You bet you it will. Will it be regressive, meaning will it hurt poor people more than it hurts rich people? Potentially, yes. And the way you solve that problem is that for people under a certain minimum income, say $50,000 or $60,000 per family, you give them a $10,000 tax credit to offset the higher cost of all the things that will be subjected to the VAT. The good thing about this tax — it’s bad because it’s a tax, OK; but the good thing about it is that it raises a huge amount of money because it’s based on everything we produce.
On the expense side, we are going to have reform the things that cost us the most money. Yes, it includes Medicare, yes it includes Social Security, yes, it includes Medicaid and other transfer payments. How do you do that? You do it gradually by recognising that we are in a different world. People live a lot longer and most of them want to work longer, not everybody, but in any event, you’ve got to make the numbers add up. So reforms in all of these areas are going to be needed and when Congress finally decides we have a major crisis, they’ll do it.
John Nyaradi: In your book, you discuss risk management; you talk about “fat tails” and people like Friedrich Gauss and Augustin Cauchy. What do “fat tails” mean to us in this new world?
Peter Tanous: Jeff and I have done a lot of interviews since the book came out and almost nobody ever asks us about this so I’m glad you did because it’s really important. We have a chapter about the history of risk and how our understanding of risk in investing has changed over the centuries. I have to acknowledge a friend who has inspired me greatly and who endorsed this book very heartily and that is Nassim Taleb. Nassim Taleb wrote, “The Black Swan,” a book that has sold over three million copies and totally revolutionised our understanding of risk.
Here’s the main problem and I’ll try to do this in a nutshell. Most modern portfolio theory evaluates risk in investing along a very symmetrical bell curve. This is attributed to Friedrich Gauss and is referred to as the Gaussian bell curve. It is from this symmetrical curve that we deduced the risk of various events so that we might say that a stock market crash of 300 points is something that would occur based on this set of probabilities only once every 500 years.
So what happens when in it occurs three times in two years or even more often? What does that tell you? Well, I think what it tells you is that the neat distribution of probabilities we used to rely on is no longer true. And this is where an economist called Mandelbrot developed something called fractal economics and then the author Nassim Taleb, whom I just mentioned, talked about the black swan.
What is the black swan? It is metaphor for the fact that in the western world, all swans were assumed to be white. So a black swan was considered an impossibility until somebody finally saw one and they were native to Australia. So a black swan is a very highly improbable event and the problem with them is that they occur at random intervals, their frequency cannot be predicted. But what we learned in 2008 when the stock market went down 40% in one year is that we damn well better be prepared for these or else no matter how careful we think we’ve been, our savings can get wiped out.
John Nyaradi: This had been a very serious conversation about a serious subject. Is there anything else you’d like to add? Is there one thing that’s really on your mind right now that people should watch out for and be aware of as we talk here in the mid summer of 2011?
Peter Tanous: John, I think the best advice I can give, and now I’m putting my investment consultant hat back on, is that if your retirement portfolio was set up, say, anytime in the last 20 years, you probably have an outdated asset allocation. Meaning you probably have so much in bonds and so much in stocks and maybe a few little other things and this is what you’re counting on for retirement.
Today’s asset allocation for portfolios looks very different. For one, you must have an allocation to real assets like gold and like oil and we have chapters on both of those in the book. And you must take a very different view of bonds. Today, bonds yield nothing and probably the riskiest thing you can own today is a 10-year bond because when interest rates double, as I think they will, that bond will lose half its value for a period of time. So you look at your asset allocation and try to understand how the world has changed and adjust your investments accordingly.
John Nyaradi: We’ve been talking with Peter Tanous, author of Debt, Deficits, and the Demise of the American Economy, which he wrote along with Jeff Cox. The book has received great reviews from people like Nassim Taleb, author of “The Black Swan,” former ABC news correspondent Sam Donaldson, Dr. Arthur Laffer, chairman of Laffer Associates and it begins with a great foreword by Rick Santelli of CNBC.
I’d like to add my humble endorsement and say this book is a milestone in financial journalism and one you really don’t want to miss. You can just follow the link at the end of this interview that will take you directly to Peter’s page at Amazon.com where you can learn more about Debts, Deficits and the Demise of the American Economy and how it can help you navigate your way through these treacherous times.
Peter, it’s really been wonderful talking with you today. Thank you so much for joining us and we’re all looking forward to talking with you again.
Peter Tanous: Thank you, John. You’ve got a tremendous website, you do a terrific job.
John Nyaradi: Take care, Peter. Thanks. We’ll talk soon.