Warren Buffett famously explained to his shareholders in 2004 that investors “should try to be fearful when others are greedy and greedy when others are fearful.”
My version of that statement, which will never become famous, is that “things are never as good as they seem and they’re never as bad as they seem.”
The first part of that statement seems especially appropriate in today’s economic climate. Financial markets are hitting record highs, the European fiscal crisis has receded, and the world is awash in liquidity.
So why not, as they say in New Orleans, laissez les bons temps rouler!
This is where Buffett’s advice comes in handy. Perhaps, instead of letting the good times roll, this is the time to be worried.
What if financial markets are experiencing a bubble, in part because of excess liquidity, and what if the fiscal crisis in nations such as Greece, Italy, Spain, etc, is simply on hold because of easy money and bond-buying by the European Central Bank?
There certainly are specific reasons for pessimism, including the fact that many European nations had the wrong response to the fiscal crisis. With a few exceptions, such as the Baltic nations, European governments used the crisis to impose big tax hikes, including higher income tax rates and harsher VAT rates.
That’s certainly not a recipe for economic growth and job creation.
Combined with the fact that Europe’s demographic outlook is rather grim, it’s not difficult to concoct unpleasant scenarios for the continent. And there’s still plenty of dismal data for nations such as Portugal, France, Greece, Italy, Poland, Spain, Ireland, and the United Kingdom.
Optimists say that nations have weathered the crisis, but what if this is merely the calm before the storm? More specifically, what if Europe’s fiscal day of reckoning has merely been postponed because of central bank intervention? And if you really want to dwell on possible bad news, what if the European Central Bank has created an unsustainable bubble in Europe’s financial markets?
There’s also cause for concern on the other side of the Atlantic as the Federal Reserve continues to pump liquidity into the economy. If you ask five economists what this means, you’ll probably get seven answers and they’ll all disagree. It’s possible that the central bank has provided appropriate liquidity and it will soak it up at the right time.
But what if Bernanke is in over his head and that the Fed is engaging in the monetary version of Keynesian economics? If that’s true, something bad will happen at some point. If there’s too much liquidity out there, it presumably will show up at some point as either rising prices or an asset bubble. Or maybe it already is an asset bubble.
In any event, we have several possible bad outcomes because of central banks. Bad outcome #1 is that all the easy money winds up causing higher inflation, which can cause considerable harm to investors depending on the structure of their portfolios. Bad outcome #2 is that central bank-instigated bubbles pop, causing a sharp decline in financial markets.
There’s also bad outcome #3, which isn’t the fault of central banks, but it will manifest itself when the morphine of easy money is no longer enough to paper over the fundamental fiscal imbalances of Europe’s welfare states. That presumably means big problems in the “Club Med” nations, but it doesn’t take much imagination to envision the fiscal crisis spreading to nations such as France and Belgium.
That doesn’t sound like much fun for investors, but now let’s add two more pieces of bad news to the discussion. When the fiscal crisis reappears, politicians are going to explore every possible option for collecting more revenue. But they’ve already pushed some tax rates so high that it’s quite likely that they’re beyond the revenue-maximizing level on the Laffer curve.
This means they’ll be searching for new and different revenue sources. One option that’s already in the works is a financial transactions tax. The European advocates of this levy are running into some logistical challenges, but one suspects they’ll overlook those obstacles if the search for more cash gets desperate.
The financial transactions tax obviously wouldn’t be good news for investors and money managers, but that may be the least of their troubles if politicians also move forward with a wealth tax. This idea recently garnered attention after it was floated in a report by the International Monetary Fund. The IMF has since backed away from the idea, but it’s easy to foresee politicians – when the going gets tough – setting their sights on the trillions of dollars of private wealth in financial markets.
The IMF actually argued that a wealth tax wouldn’t harm the economy, but its analysis was based on the untenable assumption that the levy would be a one-time confiscation of existing assets. But that’s like assuming a crocodile will become a vegetarian after gorging on a wildebeest. In any event, investors doubtlessly will expect to get hit again once the tax enters the public realm.
The economic impact won’t be pleasant. Let’s use a simple example. Imagine a rich person with $10 million of wealth. And let’s further assume he’s a savvy investor and earns a 5 percent return on my capital (not bad in this environment), so his $10 million is now worth $10.5 million. But if the government wants to grab $300 thousand because of a new wealth tax, that is akin to a 60 percent tax rate on annual earnings!
And don’t forget that the tax authorities will probably be grabbing some portion of that additional wealth because of income taxes, capital gains taxes and double taxation of dividends. So here’s the bottom line: The wealth tax is really a tax on saving and investment. And the tax rates are likely to be very high.
Now let’s add one final bit of bad news, and it’s not hypothetical. But to understand the bad news, we first need to consider some good news. Dozens of nations have fully or partially shifted to mandatory private savings as a pro-growth way of modernizing bankrupt tax-and-transfer social security systems.
But good news in the short run doesn’t mean good news in the long run if revenue-hungry politicians decide to loot the wealth accumulated in personal retirement accounts.
That’s already happened in Argentina and Hungary, and most recently it happened in Poland.
The thievery of the Polish government is a helpful reminder of why it’s good to have some of your money offshore, preferably managed by a non-resident company. After all, does anyone doubt that politicians – in the United States and elsewhere – are capable of the same venal behavior? They’re probably looking at the money in pension funds and other private savings vehicles and salivating at the thought of how many votes they could buy with all that money. If (or when) that tragic day arrives, the people who have their money beyond the grasp of their governments will be very happy.
With any luck, all of the grim scenarios outlined above will never materialize. Perhaps central banks will withdraw all the excess liquidity at just the right time. Perhaps European politicians will rein in public sectors and put their governments on a sound fiscal footing. And perhaps various schemes to tax private wealth will fade away.
But it never hurts to plan for the worst.