The idea of salami tactics that were first popularized by the communists and
Marxists in the run-up to and after the Russian revolution attained a new level
of public awareness after the idea was explained in detail during the first
episode of the first series of the cult British comedy, Yes, Prime Minister.
Script from the episode details the exchange between the prime minister and his
chief scientific advisor (CSA) on whether a nuclear deterrent had any practical
or operational credibility (here the prime minister is writing in the first
person and the CSA is the second person):
"'Why does the deterrent deter the Russians from attacking us', that's what he
was asking. Because, I replied firmly, they know
that if they launch an attack I'd press the button."
"You would?" He sounded surprised.
"Well I hesitated, wouldn't I?"
"Well would you?"
"In the last resort, yes. Definitely." I thought again. "At least I think I
His questions continued relentlessly. I had to think carefully.
"And what is the last resort?"
"If the Russians invade Western Europe." That at least seemed quite obvious.
[CSA] Professor Rosenblum smiled. "But you would only have 12 hours to decide.
So the last resort is also the first response, is that what you're saying?"
Was that what I was saying? It seemed crazy.
The Chief Scientific Adviser stared at me critically. "Well, you don't need to
worry. Why should the Russians try to annex the whole of Europe? They can't
even control Afghanistan." He shook his head. "No. If they try anything it will
be salami tactics."
[Salami tactics was the description customarily given to slice-by-slice
maneuvers, ie not a full-scale invasion of the West, but the annexation of one
small piece at a time. More often than not, the first steps would not be
annexation of land but small treaty infringements, road closures, etc. Ed]
I have thought about salami tactics a lot recently because of the ongoing rally
in risky assets across the markets after a summer filled with doubts about the
very real possibility of a double dip recession that seemed inevitable for both
the US and Europe.
Ups and downs in economic cycles aside - in other words it doesn't really
matter if the next US payroll report is a negative 24,000 or negative 125,000;
rather what matters is the long-term (secular) direction of the US and European
economies. When I wrote
The Short List before the summer break (Asia Times Online, July 3,
2010), it made several key points about trends; and even as markets have been
range-bound, those issues have come back to the front boiler.
If there is one thing that reading various books written on the events leading
up to the 2007 financial crisis has highlighted, it is that very intelligent
people failed to see the crisis developing right in front of their eyes simply
because they were left to obsess over mundane and ultimately useless details -
such as credit ratings, mortgage scores and loans-to-value - rather than the
more important holistic questions involving broad strategy and sustainability.
At the current juncture we appear to be heading for a farcical repeat of
history as investors out there are being distracted away from thinking about
the following two major (secular even) themes that are likely to dominate the
investment landscape for many decades to come. This is the financial and
economic equivalent of the old "the Russians are coming" cliche. These are:
The burgeoning pensions crisis in Japan, Europe and the United States.
Declining profit potential of companies located in Japan, Europe and the US.
These are significant stories, and they are also inter-linked because the
declining consumption of goods and services predicated by an aging population
in Europe and the US feeds back into the lower margins for companies based in
these countries until eventually the only ones that can afford to operate in
these areas are the ones for whom the provision of products and services
signifies a marginal cost to the "main" business of making profits in Asia,
Latin America and (eventually) Africa.
Add to this the notion of persistent deflation, which appears inevitable, and
it is clear that the credit risks of owning debt in these parts of the world
far outstrips the immediate (ie short-term) attractiveness of owning
government-issued or highly-rated bonds.
There is a further linkage here - as markets have panicked themselves into
buying government bonds, the resulting decline in bond yields means that the
present value of pension obligations has escalated dramatically. Much like in
the case of Japan, lower current returns on a rising debt load mean that an
eventual increase in debt would prove unsustainable.
In the first instance, I would like the world to wake up to the dangers of
Japan blowing itself up spectacularly over the next decade or so; and in the
second, remain cognizant of similar risks bubbling to the surface in Europe and
the US. Considered in that light, the "Great Sovereign Debt Crisis" of 2010
would likely seem like a measly appetizer of the sort that supermodels feed on
before a fashion shoot; before the main event namely a full blown global
sovereign credit crisis emerges by 2020.
Even if investors were to not pay attention to these facts, they should at
least remain cognizant of recent historical returns. Bloomberg shows the
following chart for the Dow Jones Industrial Average for the period from
September 1999 to September 2010, ie a range of 11 years. Over the period,
precious nothing has happened despite the gut-wrenching volatility of these
years. The world's most-watched stock market has (basically) produced no real
returns at all, even before one considers the vagaries of inflation:
Over a similar period, namely from 2001 to the present, Bloomberg shows the
following chart for current yields on the US 10-year government bond yield,
highlighting the amazing bull market in bonds, which is unlikely to be repeated
for the next few years if for no other reasons than purely mathematical ones.
But we have seen this movie before, even if our brains refuse to acknowledge
this reality. This was called Japan, and it has played in front of our eyes for
the past 20 years (note here that the graph is slightly misleading in the sense
that the purported "negative" return for the bonds, ie Japanese government
bonds (JGBs) is actually a positive figure that signifies deflation, in turn
feeding into the compound negative return for equities over the period):
Rising government debt
All of this is relevant precisely because of the vast increases in the present
value of pension obligations once we start playing around with expected
returns. For these purposes, the present value is the amount you would set
aside today, with certain assumptions on returns. A sample calculation is shown
below, which compares the immediate (present) value (PV) of a constant stream
of pension payments of say 25,000 per year with the usual simplifying
assumptions on timing. With that in mind, a typical long stream of income
requirements (over 15 years, which is consistent with the increased life
expectancy in the US, Japan and Europe) shows an exponential increase in the PV
- a simple change from 5% to 1% takes the PV up five times, to 2.5 million,
from 0.5 million.