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White Paper
July 2010
Exhibit 1
3 Sector Financial Balances Map
Domestic Private
3 Sector Financial BalancesSector
Map Financial Balance = Current Account Balance – Fiscal Balance
Domestic Private Sector Financial Balance = Current Account Balance - Fiscal Balance
Fiscal Surplus
DPS Deficit
DPS Surplus
Domestic Private Sector
Financial Balance = 0%
DPS Surplus
Fiscal Deficit
Source: Parenteau (2010)
GMO
Source: Parenteau (2010)
2 Is Austerity the Road to Ruin? – July 2010
the Gold Standard seems to have produced remarkable share the hallmark of being adjustments occurring in
results in terms of real growth: the U.S. economy grew small, open economies with weak currencies at a time of
by 11% in 1934, 9% in 1935, and 13% in 1936 in real generally healthy global growth. These are about as far
terms! This lulled the authorities into thinking that all removed as one can imagine from the circumstances that
was well with the system again. Hence, in 1937, the the world faces currently.
deficit was reduced by approximately 2.5% of GDP.
If the examples of history are ignored (as is all too often
Monetary policy was also tightened. As Romer notes,
the case) then policy error is likely to be a serious source
“… the Federal Reserve doubled the reserve requirement
of deflationary pressure. This is the last thing a debt-
in three steps in 1936 and 1937… taking the wrong turn
laden economy needs, especially a debt-laden economy
in 1937 effectively added two years to the Depression.”
that is teetering on the brink of deflation anyway. But
Lesson V is also of marked interest as the Austerians seem that doesn’t mean that policy makers won’t try to tighten.
to have gained a higher degree of influence in Europe Indeed, one of the world’s worst economists and a
(including the U.K.) than they have currently in the U.S. paragon of orthodox belief, Alan Greenspan, opined in
Japan provides us with another example of the unerring a recent Wall Street Journal OpEd that “an urgency to
ability of policy makers to snatch recession from the rein in budget deficits” is “none too soon.” Did you need
jaws of recovery. Time and time again in the post bubble more evidence that this was a really bad idea!?!
period, the Japanese policy makers have beaten an Exhibit 3
Exhibit 3
incipient recovery over the head with overly aggressive G7 Inflation (YoY, %) – No margin for error
tightening measures. Most relevant for the Austerians
14
was the experience in 1997, when the authorities raised
the consumption tax by 2% and plunged the economy 12
back into a recession. 10
Exhibit 2 8
Japan:
Exhibit 2 A prima facie case against premature 6
tightening (YoY, %) 4
8
2
Consumption tax
6 increase
0
4
-2
2 Jan-1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
0 Source: Datastream
-2
4 Alesina and Ardagna, “Large Changes in Fiscal Policy: Taxes vs. Spend-
5 Blanchard
ing,” 2009; forthcoming in Tax Policy and the Economy, available at: and Cottarelli, “Ten Commandments for Fiscal Adjustment in
http://www.economics.harvard.edu/faculty/alesina/recently_published_ale- Advanced Economies,” 2010, http://blog-imfdirect.imf.org/2010/06/24/
sina ten-commandments-for-fiscal-adjustment-in-advanced-economies/
Exhibit 4Exhibit 4a
GMO 7-Year Asset Class Return Forecasts
As of June 30, 2010
-Expected Value Added
-Real Return (Asset Class Index)
Stocks Bonds Other
12%
10.3%
Annual Real Return Over 7 Years
10% 9.1%
6.5 % Long-term
3.7% Historical U.S.
8% 1.8%
7.2% 7.5%
Equity Return
1.5%
6% 2.3% 5.2% 5.1%
4.7%
4% 1.8%
2.3%
2.9% 7.3%
6.6%
2.9%
6.0%
4.9%
2% 1.8% 1.4%
2.9% 2.9% 1.0% 0.1% 1.0%
2.2% 0.9%3
1.1% 0.9%3 0.9% 1.4%2
0.5%
0% 0.1% -0.8% -0.4%
-2%
U.S. U.S. U.S. High Int'l. equities Int'l. equities Equities U.S. Bonds Int'l. Bonds Bonds Bonds U.S. Managed
equities equities Quality (large cap) (small cap) (emerging) (gov't.) (gov't.) (emerging) (inflation treasury Timber
(large cap) (small cap) indexed) (30 days to
2 yrs.)
±6.5 ±7.0 ±6.0 ±6.5 ±7.0 ±10.5 ±4.0 ±4.0 ±8.5 ±1.5 ±1.5 ±5.5
Estimated Range of 7-Year Annualized Returns
Note: These charts represents real return forecasts1 for several asset classes and an estimate of net value expected to be added from active management. These
forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ
materially from the forecasts above.
1
Real returns — long-term inflation assumption: 2.5% per year.
2 Alpha transported from management of global equities.
3 Alpha transported from management of global bonds.
Mr. Montier is a member of GMO’s asset allocation team. He is the author of several books including Behavioural Investing: A Practitioner’s Guide to
Applying Behavioural Finance; Value Investing: Tools and Techniques for Intelligent Investment; and The Little Book of Behavioural Investing.
Disclaimer: The views expressed herein are those of James Montier and are subject to change at any time based on market and other conditions. This is not an
offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative
purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
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