How Did You Go Bankrupt? Hemingway, China And The EU

“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
– Ernest Hemingway, The Sun Also Rises

“The opening up of new markets, foreign or domestic, and the organizational development from the craft shop to such concerns as U.S. Steel illustrate the same process of industrial mutation – if I may use that biological term – that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.
– Joseph Schumpeter, Capitalism, Socialism, and Democracy (1942)

One of the many luxuries that my readers have afforded me over the years is their willingness to allow me to explore a wide variety of topics. Not all writers are so blessed, and their output and responses to it tend to stay focused on specific, often quite narrow topics. While this approach allows them to dig very deep into particular subject matter, it can reduce the total scope of their research, vision, and advice. But don’t get me wrong; these types of letters are very important. I benefit greatly from being a subscriber to a number of letters that give me detailed analysis for which I simply don’t have the time to do the research. There’s just too much going on in the world today for any of us to be an expert in more than a few areas.

I seem to find the most enjoyment and elicit the best response when I try to give my readers the benefit of my broad scope of reading and research as I try to figure out how all the various and sundry pieces of the puzzle fit together. For me, the world is just that: a vast and very complex puzzle. Trying to discern the grand themes and detailed patterns as the very pieces of the puzzle go on changing shape before my eyes is quite a challenge.To try to figure out which puzzle pieces are going to have the most influence and impact in our immediate future, as opposed to languishing in the background, can be a frustrating experience. I often find myself writing about topics (such as a coming subprime crisis or recession) long before they manifest themselves. But I think it is important to see opportunities and problems brewing as far in advance as we can so that we can thoughtfully position ourselves and our portfolios to take advantage.

Today I offer some musings on what I’ve come to think of as the Age of Transformation (which I have been thinking about a lot while in Tuscany). I believe there are multiple and rapidly accelerating changes happening simultaneously (if you can think of 10 years as simultaneously) that are going to transform our social structures, our investment portfolios, and our personal futures. We have had such transformations in the past. The rise of the nation state, the steam engine, electricity, the advent of the social safety net, the personal computer, the internet, and the collapse of communism are just a few of the dozens of profound changes that have transformed the world in which we live.

Therefore, in one sense, these periods of transformation are nothing new. I think the difference today, however, is going to be the simultaneous nature of multiple transformational trends playing out within a very short period of time (relatively speaking) and at an accelerating rate.

It is self-evident that failure to adapt to transformational trends will consign a business or a society to the ash can of history. Our history and business books are littered with thousands of such failures. I think we are entering one of those periods when failing to pay close attention to the changes going on around you could prove decidedly problematical for your portfolio and fatal to your business.

This week we’re going to develop a very high-level perspective on the Age of Transformation. In the coming years we will do a deep dive into various aspects of it, as this letter always has. But I think it will be very helpful for you to understand the larger picture of what is happening so that you can put specific developments into context – and, hopefully, let them work for you rather than against you.

We’re going to explore two broad themes, neither of which will be strange to readers of this letter. The first transformational theme that I see is the emerging failure of multiple major governments around the world to fulfill the promises they have made to their citizens. We have seen these failures at various times in recent years in “developed countries”; and while they may not have impacted the whole world, they were quite traumatic for the citizens involved. I’m thinking, for instance, of Canada and Sweden in the early ’90s. Both ran up enormous debts and had to restructure their social commitments. Talk to people who were involved in making those changes happen, and you can still see some 20 years later how painful that process was. When there are no good choices, someone has to make the hard ones.

I think similar challenges are already developing throughout Europe and in Japan and China, and will probably hit the United States by the end of this decade. While each country will deal with its own crisis differently, these crises are going to severely impact social structures and economies not just nationally but globally. Taken together, I think these emerging developments will be bigger in scope and impact than the credit crisis of 2008.

While each country’s crisis may seemingly have a different cause, the problems stem largely from the inability of governments to pay for promised retirement and health benefits while meeting all the other obligations of government. Whether that inability is due to demographic problems, fiscal irresponsibility, unduly high tax burdens, sclerotic labor laws, or a lack of growth due to bureaucratic restraints, the results will be the same. Debts are going to have to be “rationalized” (an economic euphemism for default), and promises are going to have to be painfully adjusted. The adjustments will not seem fair and will give rise to a great deal of societal Sturm und Drang, but at the end of the process I believe the world will be much better off. Going through the coming period is, however, going to be challenging.

“How did you go bankrupt?” asked Hemingway’s protagonist. “Gradually,” was the answer, “and then all at once.” European governments are going bankrupt gradually, and then we will have that infamousBang! moment when it seems to happen all at once. Bond markets will rebel, interest rates will skyrocket, and governments will be unable to meet their obligations. Japan is trying to forestall their moment with the most breathtaking quantitative easing scheme in the history of the world, electing to devalue their currency as the primary way to cope. The US has a window of time in which it will still be possible to deal with its problems (and I am hopeful that we can), but without structural reform of our entitlement programs we will go the way of Europe and numerous other countries before us.

The actual path that any of the countries will take (with the exception of Japan, whose path is now clear) is open for boisterous debate, but the longer there is inaction, the more disastrous the remaining available choices will be. If you think the Greek problem is solved (or the Spanish or the Italian or the Portuguese one), you are not paying attention. Greece will clearly default again. The “solutions” have so far produced outright depressions in these countries. What happens when France and Germany are forced to reconcile their own internal and joint imbalances? The adjustment will change consumption patterns and seriously impact the flow of capital and the global flow of goods.

This breaking wave of economic changes will not be the end of the world, of course – one way or another we’ll survive. But how you, your family, and your businesses are positioned to deal with the crisis will have a great deal to do with the manner in which you survive. We are not just cogs in a vast machine turning to powers we cannot control. If we properly prepare, we can do more than merely “survive.” But achieving that means you’re going to have to rely more on your own resources and ingenuity and less on governments. If you find yourself in a position where you are dependent upon the government for your personal situation, you might not be happy. This is not something that is going to happen all of a sudden next week, but it is going to unfold through various stages in various countries; and given the global nature of commerce and finance, as the song says, “There is no place to run and no place to hide.” You will be forced to adjust, either in a thoughtful and premeditated way or in a panicked and frustrated one. You choose.

I should add a note to those of my readers who think, “I don’t have to worry about all this because I am not dependent on Social Security.” Wrong. A significant majority of the retiring generation does depend on Social Security and also on government-controlled healthcare, and their reactions and votes and consumption patterns will have an impact on society. Ditto for France, Germany, Italy, and the rest of Europe. The Japanese have evidently made their choice as to how to deal with their crisis. If you are a Japanese citizen and are not making preparations for a significant change in your national balance sheet and the value of your currency, you have your head in the sand.

There’s no question that the reactions of the various governments as they try to forestall the inevitable and manage the crisis will create turmoil and a great deal of volatility in the markets. We have not seen the last of QE in the US, but Japan is going gangbusters with it, and it is getting fired up in Europe and China.

Most people in most places will attempt to ignore the transformational wave barreling at them. After all, aren’t bond rates in Europe lower than ever? Indeed, French and Spanish bond yields are at their lowest levels since the 1700s, believe it or not. Isn’t the market telling us there isn’t a problem? If Japan is such a problem, shouldn’t the yen be going into the toilet by now? The US deficit is shrinking, and government spending is actually falling. Seems like the problems have all gone away.

But the problems I’m thinking about are not ones that will manifest themselves this week. The markets did not foresee the 2008 credit crisis or the last two recessions or the European crisis, even just a few months before they hit. When the world doesn’t come to an end as predicted (and there were plenty of prognostications of utter doom last decade), we seem to get complacent and ignore the basic arithmetic that you have to have more income than you have expenditures, and to conveniently forget that debt, even at low interest rates, is compounding. And yes, it is possible to grow your way out of the problem – but only if you have real growth. Now, much of the world is structurally challenged in such a way that structural imbalances inhibit growth at the rate necessary to significantly put a dent in swelling debt levels.

The Second Wave of Transformation

Contrasting with this rather negative set of circumstances is the second great transformational theme that I want to explore with you, and that is the far more positive accelerating trend in a vast array of technologies. It’s not too much of a stretch to say that we’re in a race between how much wealth and value and improvement in lifestyles human ingenuity can create versus how much destruction of wealth and lifestyles governments can destroy.

It is a tendency of ours to take our recent past and project it in a linear fashion into the future. That’s the way we are hardwired. And while we all acknowledge that change is happening faster today than it did 20 or 30 years ago, we really don’t expect the pace of change to quicken in the future. The next 20 years, we figure, will more or less unfold as the last 20 years has. Not a chance. That assumption is missing the second derivative of change – the acceleration of the pace of change.

As a thought experiment, let us assume that we were going 40 miles an hour in 1984, and by 2004 we were going 50 miles an hour. But today we’re going 60 miles per hour. It took 20 years to get that additional 10 miles per hour (from 40 to 50) but only 10 years to go from 50 to 60 miles per hour. If we continue to accelerate, we’ll be going 100 miles an hour in another 20 years!

While the impact of the internet and computers is evident, what I’m suggesting is that we are going to see multiple technologies go from deceptively hiding in the background, with the pace of change they promise frustratingly slow, to suddenly taking center stage and becoming disruptive. It will be as if the steam engine and electricity and the automobile and telecommunications all appeared at the same time, after having been developed in the background for many decades.The mobile and wireless internet, artificial intelligence and automation, the internet of things, advanced robotics, autonomous vehicles, advanced energy exploration technology, renewable energy (especially solar energy), advanced materials, the rapidly accelerating biotechnology revolution, nanotechnology, and even electronic currencies (Bitcoin et al.) are all rapidly approaching the “elbows” of their own accelerating curves. Each of these areas is going to go exponential in the next 10 to 20 years.

The change I am contemplating is not simply better phones and electric cars and a few new medical therapies. I think we are in for a radical adjustment to the very mechanisms of production and the very structure of our economic and social life.

Joseph Schumpeter described capitalism as the “perennial gale of creative destruction.” In an excellentessay on creative destruction, W. Michael Cox and Richard Alm lay out the paradox between the demise of old industries and the rise of new ones (emphasis mine):

Schumpeter and the economists who adopt his succinct summary of the free market’s ceaseless churning echo capitalism’s