The Gold Report: Back in January you said the European Union (EU) would have to make serious political decisions with "major economic consequences" in 2012. Is the EU making those decisions and what is your prognosis?
John Mauldin: It is doing its best to avoid making decisions, but is being forced to make them, ad hoc. The EU allowed the European Central Bank (ECB) to print money to monetize debt. The ECB is buying time for governments to achieve structural reform.
Structural reform, not the debt, is the problem. The debt is a symptom of bad policies, of a system set up for failure. The EU translated a theory into fact, and the theory did not work.
TGR: Is that theory the EU itself?
JM: The theory is the monetary union. If the EU had just left the trade union alone without trying to layer the monetary union on, it would have been just fine. But the EU wanted a single currency. It was part of the Europhiles' dream. The EU thinks the monetary union is the sine qua non and it is not.
Today, computers do not care about lira, pesos, drachmas, pounds, marks or francs. Computers just say, this is what this unit is worth, click, click, done. Exchange rates become pointless in an age when we are moving to an electronic currency.
TGR: What is the structural problem as you see it?
JM: The structural problem is a fundamental difference in the labor markets of northern Europe and southern Europe. There is a 30% differential over the last 10 years in the productivity costs in Germany and the countries in the south of the EU. That creates trade deficits in the southern countries.
"The structural problem is a fundamental difference in the labor markets of northern Europe and southern Europe."
If you want to balance fiscal government deficits, you have to have a trade surplus. That is the economic rule. Greece cannot balance its government budget until it balances its trade deficit. The Greek trade deficit is running at 10% because it does not produce enough goods to sell to the rest of Europe at reasonable prices. Before the monetary union, Greece could fix that by changing the value of its currency. That avenue is now closed, so it will have to reduce the relative cost of its labor.
Indeed, when you look at the data, the Greeks work longer hours and harder than Germans; they just do not produce as much at the price the Germans do. There are some reasons for that. Germany restructured its labor force early in the last decade to allow for "mini-jobs." Companies can hire workers without having to keep them on the books. You can hire him at €400/week without paying any benefits. When you no longer need them, you can fire them. Mini-jobs released excess labor; it gave German industry an outlet, and it is part of the German productivity miracle.
Mini-jobs would be politically unfeasible in Spain, Italy or Greece. Those governments believe people should get full wages for their work. Fine, but nobody is going to buy what you are making. There are consequences to solidarity with the workers.
TGR: What strong governmental decisions need to be made?
JM: The southern European countries must restructure their economies. Simply buying their debt and allowing these governments to borrow more money only means more debt owed to European taxpayers, debt that will be defaulted on.
Now, the EU countries are talking about a European banking authority that looks like the Federal Deposit Insurance Corp. The Germans hate the idea of the ECB telling them how to run their landesbanks, their regional banks, because those regional banks are really under water.
TGR: Structurally changing the labor force could take years, no?
JM: It could take years or it could change overnight.
Change can happen overnight when you have a currency. If we went back to the peso or the lira, Spain and Italy could restructure their relative labor costs immediately by dropping their currency 10–20%.
"The choices now are between very bad and disastrous."
The countries remain productive, trade does not stop. Italians could then buy less because their currency would be worth less and the Germans could buy more Italian goods because their currency is worth more.
TGR: Why is that option not being discussed?
JM: Breaking up the monetary union is horrendously expensive. It's a major—insert your favorite expletives here—disaster for everyone involved.
TGR: But the Eurozone countries lose even if they continue down the path they are on.
JM: That is the second disaster. You just have to choose which disaster you want.
The choices now are between very bad and disastrous. The northern countries want a true, full-on political union, but only if the rules clearly state that the European central authorities can take over the budgetary rules for what are now sovereign states if the states cannot get their budgets together.
The northern countries want to give Brussels the power to tell Spain, for example, how many government workers to lay off, how much to raise taxes and reduce spending to achieve a balanced budget. And the Spanish would have to sit there and take it because it agreed to those rules.
TGR: Turning to the U.S., in your speech today (Sept. 10) you inferred that politicians' knowledge that the U.S. will hit the wall unless they do the right thing has become the catalyst to do the right thing. You also said you did not like all the solutions the politicians are proposing. What solutions would you propose?
JM: We all have our own economic fantasy. Mine is more academic than philosophical. When you study the literature, consumption taxes are less damaging to the economy than income taxes. I would like to see a value-added tax created, and I would like to reduce the income tax. This can increase the total amount of taxes collected and reduce the top rates.
"Over the next four to five years, I like dividend plays and income plays, income-producing real estate, farmland if you can get it—including outside the U.S."
I would eliminate most deductions: mortgage interest, charity, subsidies. If you make $100,000 and the top tax rate is 20–24%, you will pay that rate. I would drop the bottom rate to 7–8%, and I would make the threshold for paying that rate pretty low.
I would like to see the corporate tax rate taken to 15% or 12%, and get rid of every flipping deduction.
TGR: The deductions for mortgage interest, charitable deductions and some subsidies are pretty emotional. What is the probability they will be eliminated?
JM: I think it is pretty high because it is the only way to reach a compromise. The Simpson-Bowles compromise is one of the worst proposals I have read but I would vote for it in a heartbeat because it solves the problem.
That compromise eliminated a lot of deductions and dropped the total top tax rates. Dropping the top marginal rate is actually very bullish for the economy because it allows businesses and entrepreneurs to keep more of what they make.
TGR: Will politicians who vote to eliminate those emotionally charged deductions pay for those votes when they are up for re-election?
JM: A lot of things are emotional. That is why both parties have to hold hands and walk off the cliff together.
TGR: And you are optimistic they will do that.
JM: I think they will be looking into such an abyss that it will be impossible for one party to force the other party to make all the decisions and do all the heavy lifting.
TGR: Would you also change the capital gains tax?
JM: Academically, it is preferable to get rid of the capital gains tax, but I do not think that is politically feasible, so I would leave it where it is.
TGR: Meaning no taxes on capital gains?
JM: I would get rid of capital gains period, if you go out and create something, invest in something and do something.
However, a capital gains tax of 15% will not change anybody's economic motive for investing. Same thing for a 20% top income tax rate. People will not try to avoid taxes; they will just pay them.
I would have a 12% to 15% rate for corporations, with no deductions. General Electric made $6–8 billion and paid no taxes. I read a list of 20 corporations whose CEOs earned more in compensation than the corporations paid in taxes. This is just wrong.
I would tax foreign earnings at the same rate. Bring the money back, invest it here or do whatever makes sense for the company. This will have the added advantage of making our corporations far more competitive. It will allow us to become an export machine and it will create jobs.
TGR: How do lower corporate tax rates make the U.S. an economic export engine?
JM: By dropping to lower rates we will collect more in taxes from corporations because there would be fewer, or no, deductions. Instead of giving corporations tax deductions for certain investments or for using green technology, let the market sort it out.
By and large, the government has shown itself to be incredibly bad at trying to pick technology winners and losers. The Defense Advanced Research Projects Agency (DARPA) and a few others are the exception, where funding pure research and cutting-edge development makes sense.
TGR: Your remarks today included a warning that your optimism would change to pessimism if a solution were not developed in the first half of 2013.
JM: Very pessimistic; Spain and Greece-type ugly.
TGR: How does your optimistic side look at investment?
JM: On the optimistic side, I think the technological changes Alex Daley talked about in his remarks are real. Gross domestic product is growing at 2–3% and there are companies out there compounding it at 25–30%, in the biotech space for example.
Over the next four to five years, I like dividend plays and income plays, income-producing real estate, farmland if you can get it—including outside the U.S. There is a whole world of potential investments in companies doing cool stuff: traders, hedge funds, alternative funds. Do not limit yourself to buying a few, large-cap index funds and hoping for the best.
It will be a slower-growth economy for a while. Once we get to the other side of this, we will see a fabulous bull market start in the latter part of the decade. It could be a 15- or 20-year run. The last secular bear market is getting long in the tooth. It could be over in four to five years, maybe earlier.
TGR: What does your pessimistic side say?
JM: Investors must become more defensive; more fixed income, putting more money outside the U.S. and in gold. Look for investments that produce an income and a yield no matter what happens.
Investors should still look at technologies, but should be more conservative. You almost have to see how it will unfold.
In a disaster scenario, you have to start looking at what you will do when rates go up and the U.S. has its "bang" moment. No U.S. investor has experienced that so far. We do not know what this road looks like because it is around the curve.
My pessimist side sees more disruptions in the market, more Lehman-type events, bond markets deciding one morning that they want higher interest rates.
TGR: Your pessimistic scenario included buying gold as insurance not as a moneymaking asset. Can gold protect against these disruptions?
JM: Sure. Gold will have buying power in a disruptive society. If we cannot get our collective deficit act together, I will start increasing my gold allocation.
TGR: In a diversified portfolio, what is a healthy percentage of gold in both an optimistic and a pessimistic scenario?
JM: Optimistic scenario, I would say 5% or maybe a little bit more in physical gold. In a pessimistic scenario, I would double that.
TGR: You used a technical term, saying that "yield is a bitch," and noted that 5–6% is a good number. In which industries or sectors do you find those percentages?
JM: There are companies that will pay 8–10% yields all over the board, all over the world. If you narrow your focus to U.S. companies, you will not find all of them.
Their stock price might have collapsed, even though they are in solid industries such as beer or liquor; very few countries are going to outlaw alcohol and beer. A company will not pay a 10% dividend for very long, because people catch on and buy the stock. Soon, the dividend returns to rates that are more normal. You have to be opportunistic.
TGR: In your pessimistic scenario, is that 5% or 6% yield erased?
JM: Some of it is. You will have to look for more defensive or more bond-type plays.
People reading this who are investing $100K, $500K, $1M, $2M can look at small, viable targets. If you are looking only at where the big boys are investing, you are limiting your world.
TGR: You are already widely published, why did you decide to start a subscription newsletter?
JM: People have been asking me to do it for 10 years, and I finally found the right people to do it with.
I realized that I could not write a newsletter, do the research that I am doing and run a publishing company. I needed a partner who gets the investment process the way I do. David Galland and Olivier Garret are the right people and I am enjoying our relationship.
TGR: How did you choose Yield Shark as your first newsletter?
JM: That is where the demand is, and I have been overwhelmed by the response.
We will launch Bull's Eye Investor with Grant Williams in a month. Within the next 18 to 24 months, we will have eight or nine different publications.
TGR: I like that kind of optimism.
JM: The newsletters will give me a certain amount of freedom in the way I write and research and structure my life. This will simplify my life a great deal. I am only doing stuff that I want to do.
My Thoughts from the Frontline will always be free. It will always be written on the weekend, with one major change. I will write it on Sunday night so I can have a real weekend.
That may mean the newsletter will show up in readers' boxes Monday morning instead of Saturday afternoon.
TGR: Getting your weekends back is a good plan, John. Thanks for your time and insights.
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John Mauldin is chairman of Mauldin Economics, an investment newsletter publisher, and is the author of four New York Times Bestseller books. They include Bull's Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market, Just One Thing: Twelve of the World's Best Investors Reveal the One Strategy You Can't Overlook, and Endgame: The End of the Debt Supercycle and How it Changes Everything. Mauldin's free e-letter, Thoughts From the Frontline, is sent to over 1 million people every week. He also offers The Mauldin Circle, a free service that connects accredited investors to an exclusive network of money managers and alternative investment opportunities. He is a frequent contributor to publications including The Financial Times and The Daily Reckoning, as well as a regular guest on CNBC, Yahoo Tech Ticker and Bloomberg TV. Mauldin is the president of Millennium Wave Advisors, an investment advisory firm registered with multiple states. He is also a registered representative of Millennium Wave Securities, a FINRA-registered broker-dealer. Mauldin is a spokesman for the Hard Assets Alliance.
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