Q: People talk about the United States as an empire. Is the U.S. an empire and if you believe it is, why is it, and if you don’t think it is, why is it not?

Steve Forbes: Well, the United States is an empire of freedom. We think of empire as- as imperialistic ventures like the Roman Empire or the Persian Empire, things like that, but the United States is an empire of the human spirit, people coming there trying to find opportunities. The essence of the American Dream is allowing each of us and all of us the opportunity to discover our talents, develop our talents to the fullest. That is what opportunity is about. And so the United States as a result not only is a large land mass, is one of the most populous countries in the world, but also is able to absorb people when we stick to our basic principles from all around the world and in a generation or two, there as American as anyone else, and no other entity has been able to do that. You look around the world; look at the breakup of the Soviet Union, the conflict in Lebanon, other parts of the world ethnic fighting, communal fighting. The United States has avoided that because we do have these basic principles and if you adhere to them, you’re part of the American empire.

Q: There’s this great experiment in freedom and the republic has, particularly in recent years, has an extraordinary explosion in borrowing. How much of a threat is the national debt to the sovereignty of the country?

Steve Forbes: Well, the national debt in and of itself is not the problem because when you look at the assets of the nation, if you add up all the assets of the nation, it’s over a hundred and sixty trillion dollars. The problem, they’re the unfunded liabilities of Social Security, Medicare, Medicaid; tens of trillions of dollars, about eight to ten times the size of the national debt. That doesn’t show up on the politicians’ balance sheet. They don’t want you to know what a mess they’ve created. In the private sector if you had those kind of liabilities, why you’d be joining the ranks of Enron. And so that is the real problem. And we can deal with Social Security, we can deal with the problems of healthcare, but that is where the real debt is and that’s what the politicians don’t want us to talk about.

Q: Looking back at 20th century America, can you point to a couple of pivotal moments when monetary policy as administered by the United States government created, if you will, this sort of economic mess of ignoring the idea that you shouldn’t be spending more than you have?

Steve Forbes: I think the real turning point was probably the Great Depression. When you have warfare, the power of the government expands, government borrowings go up, [and] you always get hit with inflation. But up to the 1930s, ’40s in America, after a conflict, the government geared back. It happened after the Civil War. Massive powers, but the powers are stripped away. The income tax was enacted in the Civil War and was repealed a few years later. World War I racked up a lot of debt, but in the 1920s we reduced it by a third. Tax rates were brought down. It’s hard to believe, but in the early ’20s the highest rate was 77 percent wartime taxes, cut it down to 25 percent, so we were still in the tradition.

Then came the Great Depression. Nobody then knew why it happened and it was seen as a failure of free enterprise and therefore the government had to do in peacetime to help us recover from this disaster what it did in wartime. And so with the New Deal, even with Herbert Hoover, the government assumed new powers to try to correct the flaws of private enterprise, so you had the rise of the alphabet agencies. Then in the late 1930s, the New Deal sputtered to a halt. It clearly wasn’t pulling us out of the Depression. But no sooner did that thing look like it was finally going to end, the worst of it, came the Second World War, another ratcheting up of government powers. After the Second World War, we started to ratchet back a little bit, then we had the Cold War. Everything was done for national security. Even the great Interstate Highway Bill of the mid 1950s established and eventually built 40 thousand miles of freeways around the country was done in the name of national security. Government involvement in education; had to have more scientists, national security. So as a result of this constant warfare we’ve had to fight, hot wars, Cold War and now again, the war against Islamic fanaticism, fascism, government powers have always gone up. And I think what the real challenge for the United States now is to show that we can fight these forces that threaten our basic freedoms and preserve our freedoms from excess government at the same time. No other states, no other nation, no other empire’s been able to do it. No other republic’s been able to do it. I think that’s the challenge that we face and I think we’ve got to show ourselves and the world that a free people can defend their freedoms and not give up more sovereignty to government bureaucracies.

Q: As you said, you know, after a war, we’re going to cut spending a little bit. We’re going to reduce government involvement. That doesn’t seem to ever happen. There always seems to be a reason why the government needs to spend more. So we’ve heard about cutting taxes; we’ve never heard about cutting spending. People talk about it, but it never happens. Why is that?

Steve Forbes: I think to be blunt, the reason why it’s been so difficult to cut back on government spending, to cut back on the government’s reach over the economy is because we’ve done it the wrong way. When you go after a specific government program, obviously, the beneficiaries are going to fight you tooth and nail. And beneficiaries of other programs are going to fight you because they figure, “Boy, they knock off that one, they’re gonna come after us.” You saw that 10 years ago in the mid 1990s when the Republicans took over Congress for the first time in decades, controlled both Houses of Congress. They made a real effort to ratchet back government spending. It lasted about a little over a year. They made some progress like trench warfare in World War I; they gained some ground and then lost it. They retreated. Now why? I think it’s because they were too limited in their ambitions and they made it sound like they were going take something away from people.

Well, turn the tables on the big spenders. Take, for example, one of the biggest sources of power, the tax code. Simplifying the tax code, people don’t think you’re taking something away from them, they think you’re helping them. Take, for example, Social Security. The money is there for the elderly, for those on the system or about to go on the system; the real problem is people in their 20s, 30s and 40s. So why not say, “We need to help them. We’re not going to cut their benefits; we’re going to allow them to control the money. You’re going to have the money. It’s going go into your own personal account. There will be safeguards for it, but it belongs to you, not the politicians.” People aren’t going to see that as taking something away; they’re going to think, “Yeah, we’re taking away from the politicians, not us. We own it.” Same thing on healthcare. It’s all third party. You don’t get to use it until you use it. And in the workplace, healthcare is counted as a fringe benefit, but it’s not the same thing as getting money in your pay envelope or your check. You don’t have it until you use it; whereas with something like health savings accounts properly structured, the money goes into your account. You control it so you have something. Now, if you go to say a General Motors worker, they may spend what, eight, ten, twelve, fifteen thousand dollars on your healthcare, but you don’t see it unless you go to the doc. If you had a system where you had a high deductible policy, but you got several thousand bucks a year to go into your account and what you don’t use you get to keep and have it grow tax-free, you save money, but most workers are going to think, “I’m coming out ahead.”

So that’s what you have to do. Use a little imagination; flanking movements instead of charting the machinegun. Bring in some artillery, bring in some air attack and then we can beat them. And we go after the big things like healthcare, Social Security, education, huge source of government power. Why shouldn’t parents be able to control where their kids go to school? Now, there’s a suit just filed in my home state of New Jersey, a parent saying, “The school’s failed my kid; I want to be able to take the money you spent on my kid and go to another school.” If an automobile company sells you a lemon car, they give you a refund and you go buy a car elsewhere. You don’t give the auto company more government money. So too with an education. If the school fails you, you should be able to take the money and go to a school that isn’t a lemon school. People aren’t going think that’s a cutback. The unions will, but most people think, “Yeah, right. If the school doesn’t work, I should be able to put my kid in a school that’s doing a good job.”

So go after the big things; healthcare, education, Social Security, taxes. You win there, and by golly, you’ve given a real blow to the leviathan and then you can start going after these other things because you’ve established in the people there’s a right way to do it, people think they’re coming out ahead, and then you h- occupy the high moral ground. So don’t fight by the rules of the other side; we should rewrite the rules and then we can win.

Q: One of the things that we’re taught is in times of war, the people in general have to make sacrifice. It doesn’t seem that in recent years in this War on Terror that the American people in general have been called upon to make a sacrifice and, at the same time, government spending in non-defense areas has grown. Are we in jeopardy of essentially bankrupting America if the policies that are in place now continue?

Steve Forbes: Well, this is where I think this whole area of how do we finance this war against Islamic fanaticism, how do we stop this crazy spending? Comparing the spending to drunken sailors is an insult to sailors. They are defending the country and they spend their own money; they’re not spending other people’s money. And so the government in terms of this kind of war, it’s a different kind of war, so it’s not the total war that we had say in World War II, but one of the reasons the American people are so upset with both political parties is they see there’s no firm hand on the tiller in Washington. They read about bridges to nowhere. Here we’re asking young people to go to Iraq and Afghanistan and sometimes they don’t have the equipment they need and yet we’re spending this money on frivolous stuff because a politician thinks it’s going to help him win reelection, that is what got people upset. People are willing to do what is necessary to defend the country, but we as a free people now have to take the next step. It’s not enough to be angry at these characters; we have to say, “Who are they? Let’s challenge ‘em in a primary,” as they did with state legislators in Pennsylvania who abused the public trust and beat most of them, even though the challengers had very little money, weren’t well known. We have to take on these folks and say, “Here’s what you did. You have no good explanation for it.” We as a free people are going to say, “It’s time for you to find new opportunities.”

Q: What was from your point of view in the last 25 years what Alan Greenspan did that was great and what he did will not be looked at as one day in history people will look back and say, “What was he thinking?”

Steve Forbes: Well, Alan Greenspan was a good crisis manager when things went wrong in Asia, when things went wrong in Russia. When we had a stock market crash in 1987, he was right in there making sure that panic didn’t spread, containing it. But his greatest failure was he was like a pilot who didn’t fly with instruments; he flew by the seat of his pants. He had good instincts, but if you’re flying by the seat of the pants and you get some adverse weather, sometimes you’re going to hit a tree or a mountainside. And so as a result, he left no legacy to a successor on how you properly conduct monetary policy, i.e. how does he know on a day-to-day basis whether he’s doing his job right or wrong? There is no fuel gauge. Imagine driving a car without a speedometer and without a fuel gauge. You’re going to always be wondering. So he didn’t provide the speedometer, he didn’t provide the fuel gauge. What’s the best speedometer, fuel gauge for monetary policy? Look at the price of gold. If it’s zooming up, that means you’re printing too much money. If it’s crashing down in price for a period of time, it means you’re printing too little money. Gold reflects the markets. Let markets tell the Federal Reserve whether it’s doing its job right or wrong instead of always guessing what is the right interest rate and getting sidetracked and detoured on things they shouldn’t be concerned about. Keep the dollar stable in value. Tie it to the price of gold or to a range, a little bit of flexibility. You’ve got to give these people something to do each day, but have that kind of gauge and then guess what? You don’t make huge mistakes like we have today with oil zooming up and other crises out there. That kind of instability hurts. We want stability, not instability. We don’t want inflation or deflation, we want ‘flation.

Q: Should we be back on the gold standard?

Steve Forbes: Should we be back on the gold standard in terms of having a pile of gold? No. All you need to do is look at the price of gold and base your monetary policy based on the price of gold. In short, I’ll pick a number, 400 dollars an ounce. If it goes above 400 dollars an ounce, you’re printing too much money, mop it up like you spill something in the kitchen, you mop it up. If it goes well below 400 for a period of time, you know, you’re not creating enough credit for the needs of the economy, so you print a little more. You let the markets, the economy tell you what to do. You don’t try to second guess what’s needed like setting interest rates and hoping you targeted it right. Markets will tell you.

Q: As a holder of some dollars, is the value of the dollar starting to depreciate at a rate that is of concern to you?

Steve Forbes: The dollar should never depreciate or appreciate. It should be stable in value. It should be fixed in value. Say a foot has twelve inches; you don’t change that each day, appreciate it or depreciate it. It’s a fixed measure. Same thing with an hour; sixty minutes in an hour, it’s fixed. You don’t change the number of minutes in an hour each day. The dollar should have a fixed, basic value. Gold, for all its imperfections, is like a Polaris. It’s the best thing we have out there. Experience shows that. Keep the dollar stable in value and then you can focus your energies on more productive things like innovating, starting a business, building a house or buying a house, being responsible, moving ahead in life.

If you don’t have a currency that is fixed and has a fixed measure of value, then the temptation always is to, as they said in times of old, clip the coins, reduce the content. Politicians love to spend and they hate the idea that there’s any discipline out there. So without discipline, guess what happens? You get inflation, you get chaos, you undermine it. Lenin said the best way to undermine a society is to debauch the currency because not one in a million people understand what is happening. Inflation is great for those who want terrorism, for those who want totalitarianism, for those who want chaos. That kind of chaos is the enemy of freedom. Stability is the friend of freedom; chaos is the enemy.

Q: Given that, how dangerous is our profligate spending to creating the inflation that could create chaos?

Steve Forbes: Well, the spending is not just a monetary issue, spending is a moral issue. You’re taking money from people and wasting it. People are forced to give money to the government, presumably in return for services. As we said in our Declaration of Independence, to secure certain rights, period, not all the other stuff they’ve gotten into. And then Liberals will say, “Well, you mean you want to take away Social Security?” No, we want a system where people own the assets so they truly have something of true value there. They’re not burdening other generations. They’ve earned it, they’ve built it, the assets are there. They can have a far better, richer retirement than they can when the politicians control it. This is the way you fight these things, by emphasizing we come out ahead. We do better when it’s in the hands of we, the people and not politicians who have no sense of restraint or discipline.

Q: What do you think is the greatest threat to the stability of the United States at this point?

Steve Forbes: The real threat is bad ideas. A lot of bad ideas came out of the Great Depression, that government could be a stabilizer of the economy, that government could do better than free markets. We’re recovering from the devastation of the Great Depression, but bad ideas are always out there, that high taxes are good, that low taxes mean deficits. No, low taxes mean a more vibrant economy. The problem with deficits comes from spending, not from a lack of revenue. So fighting these bad ideas, fighting bad conventional wisdom, those are the things that ultimately can undermine a society.

Q: What’s the worst conventional wisdom in Washington today?

Steve Forbes: What’s the worst conventional wisdom in Washington today? Oh, where does one begin? It’s the idea that these folks are there to help you.

Q: How big a mess are we facing with the major entitlement programs, Social Security and Medicaid; as they say, the rat moving to the snake as it gets closer to retirement each year?

Steve Forbes: Well, the problem with entitlements is that someday you have to pay for them. And if you haven’t built the assets to pay for them, then you got a big problem. And I think that’s why properly putting out there proper Social Security reform where it doesn’t look like you’re taking something away from grandma, who thought she was promised something, but actually helping younger people with their own personal retirement accounts, that’s a positive. You change the entitlement to something where people feel they’ve earned it. Part of the problem with Social Security is people who are on it felt, “Well, we put money in the system, but the politicians mishandled it.” So people were cheated. They were deceived. Now we’re going to finally tell the truth to younger people. “The money that you put in is actually yours. It’s not been stolen by politicians.” So truth is the way you fight these things.

Q: Mr. Forbes, in Flat Tax Revolution, you spoke about how taxes breed corruption. Can you elaborate on that? What do you mean when you say taxes breed corruption?

Steve Forbes: Well, the Federal Income Tax Code is the biggest source of corruption in Washington because of its complexity; politicians know it’s a source of power. If you sit on a tax-writing committee, you’re always going to be guaranteed political contributions for your election cycle, and as a result, half the lobbying revolves around it, trying to put changes in, amendments in. Each Bill has literally hundreds of amendments; nobody knows what they really mean. They’re for special interest, special things to change in the code which is why the code now has nine million words. Politicians love it because it’s a source of power. You have to go to them to fix the thing or to get help or to get relief or to hit your competitors. So they love it, but the American people pay a price for it.

Q: Thank you. We’re not getting into the numbers of them, but the idea of a flat tax that you’re talking about, is that something that would help us pay off this nine trillion dollars that’s sitting there so that we wouldn’t be spending all that money on debt service and we could actually rebuild the infrastructure? Is the flat tax a good tool towards that?

Steve Forbes: The flat tax wins on all fronts. It’s a great blow against political corruption, great blow against the current system of a tax code that brings out the worst in us, always thinking, “Do I get a deduction here, do I get a deduction there?” Instead, we do things for the right reasons instead of the wrong reasons. And finally, and very importantly, it means more economic growth. It means higher asset values. Ask yourself, why did housing prices go up starting in 1998? It’s because there was a change in the tax code that in effect, I won’t bore you with numbers, that removed the capital gains tax on your first- on your primary residence if you sold it. Suddenly, for most people, it did not have a capital gains tax. When you remove a tax on something, the value of it goes up; very, very basic. So by lowering tax rates, by making it simple so that people can actually understand what’s happening to them, we have a better civil life, we have a better political life, and we have a stronger economy, higher assets, more businesses being created, better jobs being created. Boy, if we can’t- with that kind of a situation, if we can’t deal with the mess that’s been created in the past, then I don’t know what will.

Q: As a proponent of the American people getting the truth, if you could pick one truth about money, monetary policy, debt, gold, what would be the most important message that the audience would get from this film?

Steve Forbes: The key thing for the American people to realize is that don’t get caught up in all the numbers. Just remember, it’s your money. When politicians spend, they get it from you. And if they say they’re going to give you a free lunch, just remember, they’re using your credit card, your money. You’re eventually going to be getting the bill.

Q: And once the American people have that knowledge and it has become second nature to them, if you will, what would be the right action for them to take?

Steve Forbes: The American people as a start should say, “Who are my representatives? Who is my state representative, state senator, congressperson, U.S. senator, governor? What are they doing, why are they doing it and start badgering them. Challenge them in primaries even if they’re not doing the job right. Go online, write a letter to the editor, be active. It only takes a few minutes each month. By golly, that’s how you get results.

An Interview with Steve Forbes originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

First, we should define some terms. The monetary base consists of currency in circulation, plus bank reserves held on deposit with the Fed itself. The base is the narrowest definition of money, and is directly controlled by the Fed. This is why economists often look at the monetary base to gauge whether the Fed is loosening or tightening.

If we broaden the scope of our definition of money, we have M1, which consists of currency in circulation, demand deposits (i.e. checking account balances), traveler’s checks, and a few other extremely liquid assets. For our purposes in this article, the essential differences between the monetary base versus M1, is that the base includes bank reserves with the Fed (while M1 doesn’t), and M1 includes checking deposits (while the base doesn’t). We’ll see in a minute why these differences are important to understanding the danger of the current situation.

At the risk of triggering nauseating flashbacks to mandatory college lectures, let’s review how the Fed creates money which in turn leads to price increases. Normally, when the Fed wants to engage in “loose” monetary policy, it engages in open-market operations by buying assets from the public. For example, the Fed might buy $10 million worth of government securities from private-sector holders. In the transaction, the Fed acquires the $10 million worth of Treasury debt, and writes a check on itself for $10 million.

This is the precise spot where money is created “out of thin air.” When the Fed writes a check on itself, the recipient deposits it at his bank, and the bank in turn deposits it with the Fed. So the Fed bumps up that particular bank’s account balance by $10 million; in other words, that bank’s reserves with the Fed have gone up by $10 million. Yet there is no counterbalancing debit anywhere else in the system.

When Joe Smith writes a check for $10,000 to Bill Jones, total deposits haven’t changed; Jones’ checking account goes up by $10,000, while Smith’s goes down by $10,000. Yet when the Fed writes a check for $10 million, some bank’s reserves go up by that amount, while no other bank’s reserves fall. The additional $10 million in reserves was created by changing the 0s and 1s in the Fed’s computer system.

As readers may recall, the process does not stop there. Because of the fractional reserve nature of our banking system, an injection of new reserves can lead to a multiple increase in the overall money stock. For example, if the reserve requirement is 10%, then the bank depositing the $10 million is able to make new loans of up to $9 million. Businesspeople may come in and win approval for loans, and receive new checking accounts with a total of $9 million in their balances. They can go out into the community and start writing checks on these balances, pushing up prices. At the same time, the original person who sold Treasurys to the Fed, still thinks he has $10 million more in his checking account too. Thus, while the monetary base has increased by $10 million (i.e. that’s how much total bank reserves have increased), M1 has increased by $19 million.

And the process continues. The merchants who receive payments from those taking out new loans will in turn deposit the checks with their own banks, and some of the “excess reserves” (i.e. the $9 million that the original bank held over and above the legal minimum needed to back up the first person’s deposit) are transferred to other banks. They in turn can now make new loans, because the 10% reserve rule applies to their new reserves as well.

In the end, if we assume a 10% reserve requirement, and that all of the banks are fully “loaned up,” then the original purchase of $10 million in Treasurys will yield an increase of $100 million in total checkbook balances in the community. Prices for goods and services will be higher than they otherwise would have been, because there is now an extra $100 million in household “cash” chasing them.

The process works in reverse, too. If the Fed grows concerned about price inflation, it can slam on the brakes by engaging in open-market operations to sell off assets from its balance sheet. When the public buys an asset from the Fed, the transaction ultimately reduces the reserves that member banks hold with the Fed, meaning that they will need to contract the total outstanding checking balances of their customers. (We are assuming the banks had originally been fully loaned up, i.e. that they held no excess reserves.) Assuming a 10% reserve ratio, if the Fed sold $10 million of securities that it had been holding, that could lead to a reduction of $100 million in the quantity of money held by the public.

Now back to the current situation. The chart below shows the banking system’s total excess reserves, meaning how much banks are holding that could be used as the base on which to pyramid loans to customers.

The above chart is startling. Notice that the timeline goes back to 1929; nothing even remotely close to our current situation has occurred, even during the depths of the Great Depression.

What is happening is that the Fed has allowed its balance sheet to explode during the last year, from $920 billion in December 2007 to $2.3 trillion in December 2008. (See this excellent summary article.) Yet because of general fear, as well as various gimmicks (such as paying interest on reserves held with the Fed), the banks are sitting on these huge injections of reserves, rather than granting new loans to their customers. This is why prices have been falling, even amidst this unprecedented expansion in the monetary base.

Another way to see the discrepancy is to contrast the growth in the monetary base with the growth in M1. Remember that the Fed directly controls the base, whereas it is M1 (a measure that includes checking deposits) that most accurately captures how much money the public has available for immediate spending. Look at how much more the base has grown, compared to M1:

Sometimes when economists focus too much on the supply of money, it leads to a neglect of the demand for money. As the second chart above illustrates, M1 has indeed grown remarkably in the last year, even while prices have been fairly stable. This is because the recession and general panic has led the public to demand greater cash balances. In other words, people want to concentrate much more purchasing power in extremely liquid assets (including Treasury debt as well as currency and FDIC-insured checking accounts). Thus, even though the total stock of money has risen considerably, prices haven’t followed suit.

The general price level is the flip-side of the dollar’s strength, and so if the demand to hold dollars goes up, then its “price” goes up too, meaning its exchange value versus real goods and services goes up. In the summer, one U.S. dollar traded for a quarter-gallon of gas. Now that the dollar has considerably strengthened against gasoline, one dollar fetches (say) three-quarters of a gallon. The “gas-price” of a dollar has risen, meaning that the dollar-price of gasoline has fallen. The same is true – to a lesser extent – with other goods and services.

Even though increases in the demand for U.S. dollars can offset increases in its supply – so that its market value doesn’t plummet – this observation is no cause for comfort. Using back-of-the-envelope calculations, the year/year growth in demand deposits (i.e. checking account balances) was about 38% in December. In contrast, the year/year growth in reserves was more than 1,400%. If the banks became optimistic about the future of the economy and began loaning out their excess reserves, right now there is enough slack in the system for the public’s money supply to increase by a factor of 14.

There is nothing conspiratorial about the points I have made above. (Indeed, I have run these thoughts by other economists who are experts on the banking system and they generally endorse the analysis.) Analysts simply assume that once the recovery begins, Bernanke will wisely suck the excess reserves back out of the system, in time to tame price inflation.

But is that really going to be politically feasible? The federal government is currently borrowing money at amazing rates: if we include not just the on-budget (cash flow) deficit, but also the government’s overall long-term financial liabilities, then the total federal debt increased by more than $1 trillion in 2008 alone. When we consider that Bernanke and Paulson have extended more than $5 trillion in new taxpayer exposure with all of their bailouts, the pressure on Uncle Sam in the coming years could be enormous.

Why is the federal debt relevant to our discussion? Well, recall that in order to soak up excess reserves from the banking system, the Fed will need to sell off its assets. If it uses its vast holdings of Treasury debt to do so, then the massive dumping will raise U.S. interest rates, just as surely as if the Chinese government decided it no longer thought the U.S. government were creditworthy and dumped all of its Treasurys. Bernanke will therefore be reluctant to go that route.

But his other options won’t be pretty either. The Fed has acquired all sorts of dubious assets in the last year, in an effort to provide “liquidity” to the financial sector. Is Bernanke really going to paralyze the big banks by throwing billions of mortgage-backed securities onto the market, just as the economy limps out of recession and into recovery?

The Federal Reserve under Ben Bernanke’s leadership has painted itself into a very tight corner. He has cleverly managed to stave off utter disaster so far, but he is running out of options. Ironically, the effects of his incredible injections of new reserves have been masked simply because the financial sector is still paralyzed. If and when the economy begins to improve, Bernanke will have to decide whether to allow double-digit price inflation or instead contain prices by strangling the incipient recovery.

Regards,

Robert P. Murphy
for The Daily Reckoning

Editor’s Note: Robert P. Murphy has a PhD in economics from NYU and is author of The Politically Incorrect Guide to Capitalism (Regnery 2007).

He runs the blog Free Advice.

Bernanke Paints Himself Into a Corner originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

One argument advanced in the attempted exoneration of Greenspan is that he didn’t really pump that much money into the credit markets. For example, popular blogger Megan McArdle writes,

"Both right wing Austrians and many liberals have a common theory of how all this happened: Alan Greenspan dunnit. The mechanisms by which he accomplished his foul task are different in the two cases, of course. Austrians, and many other free-market types, believe that by lowering short-term interest rates after 9/11, Alan Greenspan made the housing bubble, and its eventual bust, inevitable… Here’s the problem: if markets are so great, how come the entire system can be brought low by a smallish injection of short-term capital?"

Brad DeLong makes a similar claim in his critique of Larry White, whom DeLong praises as the "best of the Austrians." (DeLong does not tell us who the best-looking Austrian is, though I hope to at least be nominated.) DeLong writes,

"Moreover, I do not think that Larry White has gotten the part of the story that he does cover right…. From the start of 2002 to the start of 2006 the Federal Reserve bought $200 billion in Treasury bills for cash. This $200 billion reduction in outstanding bonds and increase in cash surely did lead to an increase in demand for private bonds. But recall the magnitudes here. We have $2 trillion of losses on $8 trillion in face value of mortgages that ex post should not have been made. Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans? Not likely. I can see how monetary contraction can make previously profitable loans unprofitable. But I see no way that this amount of monetary expansion can force private agents to make that amount of unprofitable loans. The magnitudes just do not match."

Similarly, David Henderson and Jeff Hummel write that monetary growth was tamed during the years of the housing boom, and so Greenspan can’t be the culprit:

"A better, although now unfashionable, way to judge monetary policy is to look at the monetary measures: MZM, M2, M1, and the monetary base. Since 2001, the annual year-to-year growth rate of MZM fell from over 20 percent to nearly 0 percent by 2006. During that same time, M2 growth fell from over 10 percent to around 2 percent and M1 growth fell from over 10 percent to negative rates. Admittedly the Fed’s control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base since 2001 fell from 10 percent to below 5 percent in 2006 and by June of 2008 was around 1.5 percent, despite Ben S. Bernanke’s alleged reflation. When all of these measures agree, it suggests that monetary policy was not all that expansionary during 2002 and 2003 under Greenspan, despite the low interest rates."

I realize that these disputes may just further convince some readers that economics is not a science but rather an ideological contest in which each side throws its own set of lying statistics at the other. But even so, I will now use the same underlying data as the writers above, to reach the opposite conclusion: Greenspan allowed the monetary base to grow quite rapidly precisely when the housing boom shifted into high gear, and precisely when interest rates collapsed.

Before proceeding, I want to remind readers that my story is the textbook explanation of how the Fed operates. It is the writers above who are downplaying the Fed’s ability to push down interest rates or to "stimulate" (however temporarily and artificially) the economy. During the boom years, Greenspan and his fans wanted to take credit for his "merciful" low rates which allowed the United States to avoid a painful recession, but now Greenspan and his defenders want to claim that he was an innocent bystander in the face of Asian thrift and shortsighted bankers. In any event, on to the data, this time presented by the "prosecution" as it were.

First, let’s take McArdle and DeLong’s discussion of the injection of base money, and how it was too insignificant to cause the effects we have seen. According to DeLong, there was a $200 billion injection through open-market operations, and yet we have to explain $2 trillion in losses. Well, my first thought is that – as DeLong no doubt teaches his principles-of-macro students – our fractional-reserve system has a built-in multiplier. In particular, if the required reserve ratio is 10 percent, then a given injection of new reserves (through Fed purchases of securities) allows up to a tenfold increase in the quantity of new money. So with that rule of thumb, a $200 billion injection would be expected to have an impact of … $2 trillion.

Now let me anticipate an obvious response from DeLong. He could say, "OK fine, but that still makes no sense. Why would expanding the quantity of money by $2 trillion lead private investors to make so many bad loans?" That’s a good question, but it’s different from the issue of magnitudes. Even if Greenspan flooded the economy with $100 trillion in new money, it doesn’t automatically follow that investors should make dumb lending decisions. My point here is simply that this alleged (by McArdle and DeLong) quantitative mismatch is in fact perfectly adequate; Greenspan injected a lot more than a "smallish" amount of short-term capital, once we recall the nature of our fractional-reserve system.

Now when it comes to Henderson and Hummel, look again at their actual quotation above: they are trying to prove that monetary expansion was nothing unusual in 2002 and 2003, and to do this they quote the starting and ending annual rates of expansion in 2001 and then in 2006. But this is a bit like saying Keanu Reeves in the movie Speed didn’t drive recklessly, because, after all, the bus’s velocity was lower when he got off than when he first got on. To know if Greenspan had a tight or loose monetary policy during 2002 and 2003, it’s not enough to know that the policy in 2006 (when the boom was winding down, after all!) was lower than in 2001.

For the following chart, I have taken the annual averages of the monetary-base series (as compiled by the St. Louis Fed), and plotted the growth rates:

There are a few interesting features of the above graph. First, note that the growth rate in 2002 (8.7%) was higher than in 2001 (5.6%). (Henderson and Hummel may have given the opposite impression, because of the units involved. The base bounced around like crazy because of huge injections and then drainages because of Y2K and 9/11.) Second, note that the base growth in 2002 was about as high as any year from the 1970s, except 1979 (when base growth was 9.2%). Everybody in this debate agrees that the 1970s were characterized by excessively loose monetary policy. It is hard to see then how Greenspan’s behavior during the serious onset of the housing boom can be described as moderate.

Before leaving this section, I should acknowledge that the graph above does seem puzzling in one respect: the growth in the base during the early 2000s is admittedly large by historical standards (even compared to the 1970s), but it is obviously not unprecedented. In particular, there were larger spikes during the 1980s and 1990s.

This is true, but I would remind the reader that there was a massive real-estate bust and stock-market crash in the 1980s as well, and of course the dot-com bubble in the late 1990s. The Austrians would blame those unfortunate events on the Fed (as well as other contributing causes) too.

The last claim we’ll analyze in this article is made by the excellent Chicago economist Casey Mulligan, who writes,

"Another version of the subsidy hypothesis says that public policy encouraged low mortgage rates, which raised housing prices. I believe that housing prices would not have gotten so high if mortgage rates had been higher, but low mortgage rates may not explain why 2006 housing prices were so high relative to housing prices in 2003 or 2008. 30-year fixed-mortgage rates were around six percent per year for most of the boom, and continue to be about six percent."

No one is denying that there must be some endogeneity to the explanation of the housing bubble; after all, the federal-funds rate right now is just as low as under Greenspan, and nobody expects a housing bubble to develop. But again, I think Mulligan’s breezy claims about mortgage rates might give the reader a false impression. He is making it sound as if mortgage rates really have nothing to do with the onset of the boom, because after all they "were around six percent for most of the boom." But in fact, the fall in mortgage rates fits in very well with the serious onset of the boom.

The following chart plots the 30-year conventional mortgage rate against year-over-year increases in the S&P/Case-Shiller Home Price Index:

Thirty-year mortgage rates plummeted from about 8.5% in mid-2000 to below 5.5% three years later. The connection certainly isn’t robotic, but this period also saw a spike in monetary base growth (thus leading us to suspect Greenspan’s influence, not just Asian savers) and the acceleration in the housing boom. On this last point, consider that mortgage rates dropped from about 7% down to about 5.5% from April 2002 to April 2003. Even with perfectly rational neoclassical consumers, that would be expected to raise home prices about 17%. And lo and behold, over this same period the home price index rose about 14.5%.

In a follow-up post in the same Cato Unbound symposium, Mulligan makes an odd claim in his disagreement with White:

"Perhaps Professor White would argue that market participants expected short term interest rates to remain low for much longer than a couple of years. If so, he is on shaky ground. First, such a claim is at odds with long-term interest-rate data. As I indicated in my article, long-term mortgage rates were not low during the housing boom. It’s not hard to find commentary from those years recognizing the low short-term rates were not expected to last."

Again, this is one of those casual claims in the debate over the housing bubble that is liable to mislead some readers. Check out the following chart of 30-year mortgage rates:

Some Austrians are concerned that empirical exercises such as I have performed above will fall into the mainstream habit of aping the physicists, rather than developing a priori theories. However, we all know what the logical, verbal arguments of Mises and Hayek are, regarding the boom-bust cycle caused by central banks. The critics are claiming that this story doesn’t fit the facts. Hence, the only way to respond is to argue that the Misesian theory really does fit the facts.

Despite claims to the contrary, it appears that Alan Greenspan’s ultralow interest rates – which went hand in hand with monetary growth rates comparable to those of the 1970s – were at the very least a large contributing factor to the housing boom. I feel confident in claiming that the housing boom would not have occurred if money and banking had been left in the hands of the private sector, as opposed to the state-organized cartel that we currently "enjoy."

Regards,

Robert Murphy
for The Daily Reckoning
December 16, 2008

The above was taken from http://mises.org.

Robert Murphy runs the blog Free Advice http://consultingbyrpm.com/blog/ and is the author of The Politically Incorrect Guide to Capitalism.

Today could be a big day. The Fed could make history – cutting rates down to zero.

So far, the feds have tried trillions worth of stimulation techniques. But the economy seems strangely indifferent. Unresponsive. Frigid, even. Every week brings more evidence that the animal spirits that are supposed to make it frisky and full of life are completely missing.

More layoffs, more bankruptcies, more frauds, more incompetence, more bad news…day after day…

Yesterday, for example, the Dow lost 65 points. And it was reported that houses lost more than $2 trillion of value in ‘08.

Today, the bad news keeps pouring in. The Commerce Department reported this morning that homebuilders slashed construction of new homes, pushing November housing starts far below the worst levels in 50 years.

What can the feds do? They’ve cut rates…they’ve bailed out…they’ve lent…they’ve bought…they’ve sent out checks. Altogether, the bill for all this stimulation is stretching up to $9 trillion. But so far, all this stimulus has gotten us nowhere.

But the feds aren’t going to give up. No siree. They have no other theory…no other idea…no other concept than those given to them by Keynes, Friedman and Gon Spend, Cut Rates, Print Money.

Today, the Fed will cut rates – maybe 50 basis points…maybe the whole enchilada…the entire 100 basis points they have left.

Yesterday, we urged you to sell the dollar. We hope you followed our advice. The dollar is falling. It’s at a 13-year low against the yen. And it fell to $1.36 against the euro yesterday. Against gold, it lost another $16, bringing the price of the yellow metal to $836…an 8-week high.

What a delight! Our Trade of the Decade is now in profit on both ends. ‘Sell stocks, buy gold’ has been our advice for the last eight years. This year, the ’sell stocks’ half has done beautifully…but the ‘buy gold’ part looked a little tired. But lo and behold, cometh the Christmas season and Santa Claus comes around; gold begins to shine again. It is now UP for the year! Only about 1%…but at least it’s in positive territory.

What else is up for the year? We can’t think of anything. Once again, gold has come through. Ol’ reliable.

And today, the Fed only has 100 basis points left. It will probably cut half of them. But it might go for broke by cutting all hundred. Never before has it cut rates to zero, but heck…never before has it been confronted with a global depression.

This is not just a recession and a bear market, says Bill Gross, this is a "transgenerational" downturn. Gross manages the largest bond fund in the world, PIMCO. He believes stocks are well priced. Measured either by P/E or the Q Ratio (price compared to replacement costs) U.S. stocks are at a historic low, he says, "implying extreme undervaluation."

This is not normal. But then, neither is the circumstance. Government is muscling into the economy…pushing out private business. Government borrowing will take up almost all of the world’s savings next year. Next year will bring more regulation too. Cheap financing is gone…and the elites are turning against free-market capitalism and globalization. In this new world…government spending "crowds the private sector into an awkward and less productive corner," says Gross.

What is the appropriate level for stocks in this world, he wonders. Dow 5,000? He raises the question, but doesn’t answer it. So, we will answer it for him.

Yes, Dow 5000…it’s coming. And gold $2000.

*** Here at The Daily Reckoning we have a different theory entirely. It’s not our invention…but we like to take credit for it anyway. We saw the crisis coming not because we have better eyes, but because we are able to stand on the shoulders of giants: Adam Smith, Adam Ferguson, Jacques Rueff, Friedrich Hayek, Murray Rothbard, Josef Schumpeter and Kurt Richebächer. Not that we’ve done a thorough study of the field. It’s just that there is something so transparently superficial about the Keynesians and the Friedmanites…not to mention the Gonoists.

At the bottom of it, we don’t think the economy works like a machine. You can’t tinker with it to make it run better, in other words. You can’t turn a screw to eliminate mistakes. And you can’t trick consumers into thinking they have more money – at least, not without adverse and unexpected consequences.

No, in our mind, an economy is a living thing…organic…natural…subject to moral laws rather than mechanical rules. In our theory, people don’t get what they want or what they expect…they get what they’ve got coming. Sooner or later.

Of course, that’s why economists, government planners, and world improvers don’t much care for our pensee. The clumsy mechanics have their own jackass theories; they stick with them no matter how many times they prove not to work.

*** A remarkable issue of Newsweek offers advice to the President-Elect:

"How to Fix the World" promises the cover.

What makes the magazine remarkable is that it has managed to put between its covers more claptrap ideas and silly ‘blah, blah’ humbug than we ever seen assembled in one place.

Of course, you know what’s coming when you read the headline. If you’re going to "fix" the world, you must believe that there is something wrong with it…and that if the Obama Administration would listen to the editors of Newsweek, it would be improved. We know you can fix a fight…or fix an election…or even fix a flat tire. But whenever people want to fix the whole world, they are looking for trouble. What they really mean is "change" the world – bend it into a new shape, more to their own liking…but hideous to everyone else.

"The world needs smart management," say the editors. No kidding. That’s shows the height of bar Newsweek editors set for themselves. But what is "smart management?" And why should tomorrow’s managers be smarter than today’s?

And how is it possible to manage the world anyway? If the editors would only reflect for a minute they would realize that so far the "management" of the global economy has been disastrous. The last thing the world needs is more of it.

"Foreign policy requires adult supervision…" is another of the newspaper’s empty bon mots. Who do they have writing this stuff, we wondered? Tom Friedman maybe.

Then, in a piece entitled "How to save democracy" the authors suggest "technical assistance" and "training programs" setting "clear conditions" before the United States gives away any more money. They think that if foreign governments promise to work on "women’s rights" and "transparency," the world will be a better place.

Tom Friedman must have had a hand in this, we conclude. It is all so childishly simpleminded. ‘Democracy is a good thing,’ the editors must have said to themselves, ‘What can we do to get more of it?’

You see, dear reader, it’s the same kind of drivel that you find in economics. ‘Credit is a good thing; how can we get more?’ Or, ‘consumer spending makes the economy grow; how can we get consumers to spend more?’

The Newsweek team even offers to "fix Islam." Again, we didn’t know there was anything wrong with it. But here is where we begin to get in the spirit of this whole world-fixing scheme. It’s a shame they don’t turn their attention to Christianity. How could that be fixed, we wonder? For example, maybe the 10 Commandments could be lightened up, so as not to exclude so many people. How about just 8 Commandments…or 5…so they are easier to remember? Or, how about "Thou shalt not commit adultery very often?" Or, "thou shalt honor thy father and mother except when they are annoying?" See how easy it is to improve someone else’s religion? Maybe they could go right to the heart of the Christian dogma and improve "Love Thy Neighbor" to "Like thy Neighbor." That would make the whole thing a lot easier to live with, don’t you think?

Now that we’re in the mood to fix the planet, we will take up Newsweek’s next challenge with greater grace. Yes, dear reader, the magazine wants to fix relationships between men and women. They don’t seem to like it when women wear those black outfits that cover them from head to toe, for example.

Now here is where we can make common cause. We don’t like those black outfits either…except on women who look dreadful. But we don’t know which women look dreadful and which don’t, so we will make a suggestion; let’s fix this black bag thing with the following edict: women’s clothing should be inversely proportional to their age and beauty. The more young and attractive they are, the less they should wear. There…that should help!

And while we’re at it, we humbly and respectfully propose a simple code of ‘rights’ for women: women should be able to do anything men can do…only better. Except chew gum in public…we draw the line there. We hate to see a woman chewing gum…or swearing. Women should never swear; it makes them sound like low-bred washerwomen. Also, since we’re taking the initiative here, women should wear dresses. We know this will seem a bit retrograde, but sometimes you have to go back before you can go forward. We like to see women in dresses, and we are sure it will be a better world if women wore dresses…except, that is, for the women who wear black bags.

But we’re probably going a bit far afield from the world improvements the Newsweek team had in mind.

Let’s return to their agenda.

"Markets can’t rule themselves" says Joseph Stiglitz. We need "better regulation," he says. Now there’s a novel idea. The SEC was set up by the Roosevelt administration 70 years ago. They were actually watching over Bernie Madoff’s company…and actually did a review of it in 2005 and 2007. Somehow, these ace regulators didn’t notice the biggest Ponzi scheme in world history…a scheme approximately 5,000 times bigger than the scheme of the eponymous Ponzi himself.

Better regulation? We know how to get more regulation. But what we don’t know is how to get better regulation. We don’t even know what it means. There were thousands of regulators on the job in New York City. Not one of them seems to have caught on to any of the great scams that were going on. Even when they were so obvious even we poor scribblers here at The Daily Reckoning warned about them for years. We said sub-prime would be a disaster. We told the world that hedge funds were a rip-off. We whined about high executive salaries and bonuses. We explained how the profits going to the financial industry were an aberration. We laughed at the pretentious nonsense of the investment engineers, the pious complicity of the rating agencies, and the reckless greed of the mortgage lenders. Housing…finance…private equity…hedge funds…the dollar – what did we miss? And a subscription to The Daily Reckoning is free!

Newsweek presses onward in its delusions:

"More government is the solution" says Brazil’s President Lula da Silva. The solution to what? We would like to know what problem – that was not caused by government itself – has ever been solved by government. We can’t think of any. But so the magazine lurches on…from one bit of claptap to another…from mass delusion to popular fantasy…from farce to dada.

*** Poor George Bush. At a press conference in Iraq, a journalist called him a dog, in Arabic, and then threw his sized-10 shoe at the president. Dubyah ducked.

What’s wrong with America’s journalists, we wonder. Have they no shoes?

Until tomorrow,

Bill Bonner
The Daily Reckoning

Greenspan’s “Smallish” Injection? originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Alice Rivlin has been surprising teachers and peers since college, when she switched majors to study economics after taking a summer school class. Known as a "deficit hawk" with Robert Rubin on the team that balanced the budget during the Clinton Administration, she served as the first director in 1975 of the Congressional Budget Office, an impartial, quasi-governmental agency created by the Congress as a source of reliable, untainted numbers on the economy. Today she works at the Brookings Institution, a liberal think tank in Washington, D.C.

Q: You were the first director at the CBO. How did that come to be?

Alice Rivlin: The Congressional Budget Office, which has been around now for quite a long time, more than 30 years, was brand-new in 1975. The Congress did not have a budget office that helped them look at the federal budget and make decisions about it the way the Office of Management and Budget helps the president make his decisions. So they thought they needed one. They passed a law called the Budget Reform Act of 1974 that set up the Congressional Budget Office. And I was very lucky; I got to be the first director of that office. I was there eight and a half years. I loved it. It was a fascinating thing to do. I loved it in part because I like working for the Congress. It is a very interesting group of people, and the issues are interesting. And I think I also liked it because it was entrepreneurial. I got to set up this whole new organization. That is a little bit like starting a new company.

Q: Let’s jump ahead to 1993 and the Clinton administration. What was your title during the Clinton administration, and can you explain to me how the policy was determined in January of 1993? How did that battle go about, and how do you feel the results turned out?

Alice Rivlin: In early 1993, I was the Clinton administration’s designated deputy director of the Office of Management and Budget. The first director was Leon Panetta. Somewhat later he became Chief of Staff for the president, and I became the Office of Management and Budget director. But in the early period, even before the inauguration, when we were working out of Little Rock, we were really focused, the whole economic team was focused on what the president thought was the highest priority: Figure out what I am going to do about the budget. The budget was in deficit, [and] everybody was worried about it. We knew that if it stayed on the track that it was on, that the budget deficits would keep rising. We would have to borrow more and more money. And we would be paying higher interest rates on that government debt. So it was a high priority among the economic team to figure out how we were going to get the budget deficit to come down. We had a lot of discussion about how fast it should come down.

The president had made promises during the campaign. He had said he was going to have a big infrastructure program to improve roads and bridges. He had said that he was going to have a middle-class tax cut. He had said that he was going to do health care reform which, indeed, he tried to do. And that he was going to do welfare reform, which eventually we did achieve. But we could not figure out exactly how we were going to do all of that and still have the budget deficit coming down. So we had a lot of discussions about it, first around a big table in the Governor’s Mansion in Little Rock, and later around an even bigger table in the White House. And there was controversy within the Clinton team about how fast the budget deficit could come down. I was one of the so-called hawks, along with Bob Rubin and Secretary Benson at Treasury, and Leon Panetta. We all thought that getting the budget deficit down was extremely important to the future of the economy, and that making a strong move on the budget deficit would bring interest rates down. So we were focused on that. Others were focused on two things: One was whether the president’s campaign promises could be paid for. And the other was whether bringing the deficit down too quickly would be bad for the economy, because we thought that the recovery from the recession was a bit shaky, and nobody wanted to derail the economy and bring it to a screeching halt. As it turned out, the economic recovery was actually stronger than we thought it was going to be. So we were not skating on quite as thin ice as we thought. But that was a worry.

Q: Are you proud of what you were able to accomplish as a team and as an individual?

Alice Rivlin: I am extremely proud of what happened as a result of the Clinton budget reform. We made some really hard decisions in 1993. The president was very much into it. We spent hours and hours in the Roosevelt Room in the White House with the president discussing how we were going to cut spending, and what we were going to do about taxes. We put together a package that passed the Congress with great difficulty, by one vote in each house. That was a squeaker. But in retrospect, it worked. Interest rates came down, and the economy improved. I am not saying that was all because of the Clinton plan, but it certainly helped. And by about four years later, we not only had a balanced budget, the budget was moving into very substantial surplus.

Q: Can you tell me, was it just the White House that was able to get those victories in the late 1990s? Or did you benefit from having a Republican-led Congress, and if so, how?

Alice Rivlin: I think almost all progress on fiscal responsibility has been as a result of a bipartisan compromise. That was quite obvious in 1990, when President Bush Sr. made a deal with the Democratic Congress to reduce the budget deficit and to put in place some rules about how the Congress could consider the budget. And it was even more obvious, I think, in 1997, when the Clinton administration had to cut a deal with the Republican Congress to keep progress on the deficit going. It was not fun. It was a very difficult negotiation that went on for several years, actually, between the Republican-led Congress and the Democratic Clinton administration, with the president vetoing frequently and using the veto as a weapon. But we cut a deal. And the Budget Act of 1997 was the one that really pushed the budget from deficit into substantial surplus.

Q: Numerically speaking, what does life look like in a recession as opposed to what life looks like during economic growth and good times?

Alice Rivlin: From a budgetary point of view, recession is a very difficult thing. Now, it is difficult for everybody. People lose their jobs and companies cannot make a profit in a recession because they are not selling as much. But from the point of view of the federal budget, the result is since people are not earning as much, they are not paying as much tax, and some of the programs that the government has actually increase automatically when there is a recession – unemployment compensation, for example. More people are making unemployment compensation claims because more people are out of work. So that spending goes up, and the tax revenues go down, and you have an automatic larger deficit in a recession.

Q: In a recession, what are the key numbers that you are looking for and hoping not to see?

Alice Rivlin: The thing that economists watch all the time is the unemployment rate – how many people are losing their jobs. If the unemployment rate is going up, clearly, that is bad. It is not always the first sign of a recession. Sometimes a recession will start with profits going down, and sales going down. Those things happen before the job layoffs happen. But the thing that is hardest on most people, of course, is a rise in the unemployment rate.

Q: Let’s imagine for a moment, though, it is 1999 and 2000. If someone were to tell you what our federal debt would be, and what our deficit would be today, would you be surprised? Can you characterize the road that we have been on financially for the past six or seven years?

Alice Rivlin: In the late 1990s, the economy was growing very strongly. The stock market was rising fast – as it turned out, too fast. And all kinds of signs in the economy were positive. Unemployment was very low. And even with low unemployment we did not have much inflation. So the whole economy looked very, very good. And the federal budget looked terrific. It had a large surplus in those years in the late 1990s. It had such a large surplus that people were even beginning to worry about the surplus. My then colleague Alan Greenspan worried that the surplus was so large that we would pay off the whole national debt. I never thought that was a very serious worry, but he was genuinely worried about it.

Q: Why would that be a problem?

Alice Rivlin: Well, he thought it would be a problem because then if the government kept running a surplus, it would have to buy private securities. And that would mean that the government would end up owning bonds of states or corporations or even conceivably stock. I did not think we would ever get to that point, so I was not worried about it. But that was what was concerning him, or that is what he said at the time.

Q: But wasn’t there a flip side to that argument that we should be bolstering our entitlement programs?

Alice Rivlin: Well, when we were running a surplus in the federal budget, [that] was exactly the moment when we should have taken strong measures to shore up the Social Security system. And, indeed, President Clinton suggested that. He had a slogan for it: "Save Social Security First." He wanted to invest in the Social Security system to make sure that it was solvent for the future, before we cut taxes or did anything else with this surplus. And in retrospect, that was a very good idea. But we did not do it. People were not sufficiently concerned about the future to take the prudent measures that we should have taken to invest in the future so that we would have plenty of money to pay for the benefits that we know are going to be needed as the baby boom generation retires.

Q: It seems there is a different song that people are singing today, seven or eight years later. How would you characterize the road that we are on? Are we heading toward some severe financial difficulties?

Alice Rivlin: Right now, if you look at the federal budget, it is running a deficit and it will probably run a deficit for the next several years. Those deficits in the near term – the next three, four, five years – are not huge. They are not off the charts. We have been there before. But what is really worrisome is the longer – run future. If you look at just three programs, Medicare, Medicaid, and Social Security, the spending for those programs under current rules will rise very rapidly over the next few years – indeed, for the foreseeable future. And that is for two reasons. It is mostly because the medical programs are growing, because we are all using more medical care, more medical care per person, per patient, per anything. That has been growing over several decades, and will continue to grow.

The other aspect is the baby boom generation retirement, and the fact that we are all living longer. That is the thing that most people emphasize, but it is not actually the most important thing. It is part of the problem of federal spending going up in the future, but the medical care programs are going up even faster, and they are the biggest part of the problem. What that means is that since spending on those programs will go up automatically unless we change the rules, we will have to do something. The spending on those three programs by sometime in the 2030s is likely to be about one-fifth of everything we produce. Now, one-fifth of everything we produce is about what we now spend to finance the whole federal government. So unless we are willing to raise taxes and keep on raising them, or close down the rest of the federal government, we have got a very big problem staring us in the face in the next couple of decades.

Q: Is there a solution, and what does that solution look like? A lot of people think it is almost hopeless. How do we dig our way out of this?

Alice Rivlin: I do not think anyone should see the fiscal future as hopeless. In the first place, we are not the only country with this problem. Everybody is facing rising medical care spending. That is true all over the world. And all successful countries are facing an aging population, people living longer. So these things are part of life in all kinds of countries. And we have a good, functioning democracy. We can get together and solve these problems. We are not a poor country – it would be much harder if we were. We are a rich country. And increases in longevity and rising medical care spending are symptoms of being a rich country. However, we have got to do something about it. We have got to decide, are we getting our money’s worth for all of this spending? And who is going to pay for it? And we have to figure out how to balance the federal budget in the long run, or come very close to balancing it, because if we do not, we will just keep on borrowing, and passing the bill on to future generations who did not create this problem.

Moreover, we cannot borrow that much. We can borrow $200 billion a year as we are now doing. The rest of the world seems quite willing to lend us that much money. But when we get to the really big deficits of the future, nobody is going to be willing to lend us that much money. So we are going to have to figure out what to do.

Q: What is a deficit and do they matter?

Alice Rivlin: I think deficits matter. A deficit occurs when the federal government is spending more than it is taking in revenue. And that means it has to borrow money. Now, right now we are borrowing some $200 billion a year. That means we are not paying for the government services we are asking our government to provide. We are borrowing the money and passing that bill on to our grandchildren. Now, I do not think that is a moral thing to do. I think the real reason to not run a deficit is that it is not fair to our grandchildren or our children, future taxpayers, whoever they are, to pass them the bill for the things we want to do now.

Economically, it is also risky. If you borrow a lot of money, then you have to pay interest on it. The interest becomes a bigger and bigger percentage of what the government spends, and that is really wasted money. You do not get anything for it. And then there is the problem that people might not want to go on lending to the United States government forever. Now, much of our borrowing is from other countries, particularly from central banks in Asia, who are willing to lend us large amounts of money – but they might not be willing to do that for a long time. If they begin lending us less, then we would be in some economic trouble. Interest rates would go up. We would have to pay more to borrow from somebody else, and if it really got out of hand, we might have a spike in interest rates and a recession.

Q: Why should someone who lives in this country, and has no interaction with the government or in, say, Wall Street, know about economics and the federal government and how they work? Why should they care about it?

Alice Rivlin: Everyone should care about what their government is doing because it affects their lives very directly. If taxes go up or if spending is cut for something that you really care about, like roads and bridges, or education or health care, then you are going to feel it right away. It is not remote. People may think somehow decisions are made by other people far away, but in a democracy that is not really true. It is your representatives in Congress or in the Senate that are influencing what happens to the U.S. economy and what happens to the federal budget. So it is pretty important for people to pay attention to it.

December 11, 2008

The rally seems to be continuing. The Dow rose 70 points yesterday. Oil slid up to $44. Commodities went up too. And gold shot up $34 – to $808.

The markets must be "looking ahead"…right over the worst economic news in 60 years.

It’s the "worst spending slump since ‘42," says a headline at Bloomberg. In ‘42, the United States was at war with Japan and Germany. And it looked for a while as though we might lose! No wonder spending collapsed…the economy was shifting to a ‘war footing.’

And now spending is collapsing again. And this time the economy is again shifting to a war footing – a war against deflation. Why fight deflation? Doesn’t it lower the cost of living? Doesn’t it make it easier for poor people to eat?

Well…yes…maybe. Deflation lowers prices. Deflation favors the poor…at least in the early stages.

The number of corporate bankruptcies is expected to soar next year. According to the Financial Times’ tally, more than 300,000 businesses will go bust in America, Britain, Western Europe and Japan. Who owned those businesses? Not the poor.

You can do the math as well as we can, dear reader. Imagine that each bankruptcy puts 100 people out of work. Let’s see, that 30 million people without jobs. The middle-class unemployed draw down their savings and begin spending their pensions; the poor will have to continue to live hand to mouth. Advantage: the poor again.

Yes, it’s the planet’s first Worldwide Depression. And the planet’s first Worldwide Bailout. Now the meek are inheriting the world. The downtrodden are getting up off the ground.

The latest news from India tells us that the government is pumping $4 billion into the economy to try to pep it up. $4 billion may not be much to you…we’re now used to trillion-dollar bailouts…but India is a poor country. A billion still means something.

The latest measure brings to $60 billion the total India has committed to the fight against the slump. Even that, say critics, will not be enough. But India is not in such a bad slump – at least, not yet. GDP is moving ahead at a 7% annual rate. Indians may be poor…but they have little debt…and they’re getting less poor every day.

Our Indian colleague, Ajit Dayal, says India is in a good position:

"Our financial sector never went in for sub-prime debt. There is very little consumer credit in India. Inflation is going down; it’s expected to be only about 1% next year. The economy is still growing fast. We have a huge domestic demand; we aren’t as reliant on exports to the USA as China is. And our stocks are very cheap. You can buy companies in India now for less than the cash they have in the bank…and at 2…3…5 times earnings. There is even an oil company paying a 10% dividend. India will be just fine. And as soon as foreign investors realize it, Indian stocks will rise again."

Meanwhile, in the U.S.A., Mr. Obama hints at what is ahead. It will get worse before it gets better, he keeps saying. And if it doesn’t get worse on its own…he’ll help make it worse!

The Financial Times reports:

"While noting the US budget deficit might already surpass $1,000bn, Mr. Obama added:

"’We understand that we’ve got to provide a blood infusion to the patient right now to make sure that the patient is stabilized. And that means that we can’t worry about the deficit.’"

So you see, Republicans…Democrats…deficits still don’t matter. Even though deficits are the root cause of the present predicament, the Obama Administration is planning to give us more of them. Oh dear reader…this is going to be Hell to live through…but it’s going to be fun to watch.

We’re going to see more transfusions than in a Baltimore emergency room on Saturday night…there’s going to be blood all over the place. Deficits will hit more than $2 trillion before this is over.

And what else? The price of gold will probably go to $2,000…so take advantage of the low price now, while you can. In fact, you can still get gold for just a penny per ounce…

Yes…it’s going to be fun…

Will all these bailouts work? Of course not. The government has no real savings. What can it do? Either borrow…or just print up the money the way they do in Zimbabwe. Either way, all it is doing is shifting resources away from people who earned it…and towards people who didn’t.

It’s a hidden tax that people don’t complain about…because they don’t understand it. Who will be the recipients? The insiders, of course…but also the outsiders. That is, while the elites will skim a good deal of the loot for themselves, quite a lot of it will go to "the poor." Why? Well, two reasons – one legitimate…the other corrupt. Since the poor have no balance sheets to repair, the feds can be sure that if they give the poor money it will go right back into the economy. More importantly, the poor vote. And you can buy more poor votes for less money than you can buy rich ones.

So you see, dear reader, the poor are coming out way ahead. Everyone else is losing money…and they had nothing to lose.

Keep reading for today’s guest essay, where Alice Rivlin, who was the first director of the Congressional Budget Office, and now works at the Brookings Institution, explains why she thinks deficits matter.

*** So far, the bailouts have worked like a straightjacket. The more the feds fight against the correction, the tighter the straightjacket binds…restricting their movement even further. Already, they’ve committed more than $10 trillion in various bailout measures…and the more they try to fix the problem, the worse the problem gets.

They’ve not got much wiggle room left. As for monetary policy, the Fed has used all but 100 of its basis points. A couple more rate cuts and the key Fed rate will be zero.

Could it go below zero? Not really. But the feds could impose a penalty on cash deposits…as Switzerland once did. Or…they could simply inflate the currency so people will want to get rid of it as quickly as possible. Either way, people who save their money for a rainy day will lose money.

Of course, they’re losing money already. The real rate on savings is negative… the inflation rate is about 3% or 4% while the return from money market funds is zilch. Well, actually, zilch would be an improvement. Savers are losing a couple of percent per year – just to inflation.

Who saved money? Not the poor.

But even the savers count themselves among the lucky ones. Stocks are down about 50% worldwide. Mutual funds have gotten hammered. Hedge funds have been clipped for big losses. Leading American brand-name companies are down 50% to 80%. Middle-class Americans have seen their 401(k)s cut in half…while their houses have lost 20% of their value, and are still going down.

The poor have none of these things. In fact, the poor have no financial assets at all.

Remember the advice financial planners used to hand out: put your money into a balanced portfolio of various asset classes. One might go down…but they won’t all go down.

Oh yeah? Almost every asset class has been hit hard…growth stocks…retailers…technology…energy…emerging markets… And not just stocks, suppose you put your money into one of those nifty partnerships with swaps and SIVs and other investments the experts said were as safe a T-bonds? You’d be lucky to have anything left at all.

And commodities? Weren’t they supposed to be so scarce that they couldn’t go down? Even we cynics at The Daily Reckoning were almost convinced. We knew oil was too expensive at $147…but we thought it was fairly priced at $90. Now, it’s less than half that.

Just goes to show…you never know. You know that what must happen, will happen. But you never know how much it will happen…or when.

Now investors are losing money in EVERY ASSET CLASS – including cash. Is this a first? Maybe.

But now we can more fully appreciate the elegant wisdom and justice of the free market system. Mr. Market may be a hanging judge…but at least he’s fair.

The great asset bubble seemed to prove out the old expression "the rich get richer and the poor get poorer." But it was all a mirage, caused by a bubble in credit. The rich were getting richer…but only on paper. And now paper of all sorts is going up in smoke. The "rich" have lost a quarter to a half of their wealth. The poor have lost relatively little. Now, the rich get poorer. And the poor? Well, they will always be with us. But being poor is not so bad. Many of the middle-class lumpenhouseholders, for example, are "upside down" on their mortgages. They’re below zero, in other words. The poor – with nothing – are ahead of them.

Who would have thought?

*** The English press has focused on the personal side of the downturn.

Turns out, a lot of women who married rich men in the financial industry were in it just for the money. "Toxic wives," at least, that’s what the press calls them.

A recent article mentioned a man who had turned to his wife a year ago and asked:

"Would you still love me if I lost all my money?"

"F*** no," was the reply.

The banker thought his wife was just being playful. But when he lost his job in The City (London’s answer to Wall Street) she moved out…taking what little money he had left.

The commentators despise these women; they married men only for the money. But what’s wrong with that? Money was all these men had. Besides, anyone who marries for money earns it.

Meanwhile, the Financial Times reports on another phenomenon, said to be linked to the financial crisis. Men and women – usually married – are turning to "adultery websites" for comfort. One is called "Illicit Encounters" and features people who appear to be professionals – many from the financial industry. They describe themselves as investment bankers or stock analysts, go by handles such as "Alpha 123" or "CityGent", and say they are looking for love, romance, or just casual sex. The website charges men 119 pounds. "Women go free."

Until tomorrow,

Bill Bonner
The Daily Reckoning

An Interview with Alice Rivlin originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Much of the recent stock market collapse can be explained by panicked forced selling, rather than fundamentals. Sure, we’re going to have a long, deep recession – especially in certain sectors of the economy. But you must also keep in mind that stocks are denominated in paper money. Central banks and governments are fighting this credit crunch with the greatest wave of inflation in history. I’m betting they’ll succeed, albeit with many consequences.

During the panic, I read many misleading statements about stock valuation. From day to day, stocks are, obviously, worth whatever the potential buyer is willing to pay. In panics, sellers overwhelm buyers.

But over time – in normally functioning markets – a stock’s price will reflect its ability to deliver free cash flow to shareholders. The next two or three years of earnings are only a small fraction of any stock’s value.

Yet many great companies, including National Oilwell Varco, quickly crashed by 70% or 80%, just because earnings might temporarily slow. NOV’s real value did not fall that much. This was an emotional overreaction, so we took advantage and picked up some cheap call options.

The value of any company depends on factors like future sales growth, profit margins, and capital investments necessary to sustain its business. In short, the value of companies, or stocks, doesn’t really change very quickly from week to week.

But the market can change its expectations very quickly, especially when fear overwhelms rationality.

Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, recently described how fear and stress can impact the stock market:

"The whole story of how humans deal with stress is really interesting, but there’s one facet worth emphasizing. When people get stressed, they tend to dramatically shorten their time horizons. If you’re a zebra being pursued by a lion, turning off systems for digestion, reproduction, immunity, and growth makes all the sense in the world because the chase will be done, or you will be done, in short order. But humans, who have many of the same physiological responses, are not dealing with a short-term threat, but rather a long-term system called the stock market. So taking a long-term view is absolutely crucial, although really hard."

Most investors have clearly been acting under dramatically shortened time horizons. Redemption requests and margin calls have forced many fund managers to sell what they don’t want to sell at ridiculously low prices. But it finally seems we are heading back into a normally functioning market – where investors can make informed decisions without so much fear and stress.

A more orderly stock market will give us plenty of attractive short ideas. I’ll be looking for situations in which the market has already priced in a rosy scenario for a stock. We can all become better investors by honing our abilities to distinguish between the trading noise and the investing signal. In other words: What really matters to the value of this company, and what does not?

It’s amazing how often the market projects the fundamentals of the past year into the infinite future. Those who invested in bank stocks two years ago have discovered the hazard of investing on the assumption that the future will look just like the past. The same goes for traders that chase the latest hot stock up to the stratosphere, to the point where it must keep growing earnings at 30% per year for a decade to justify its valuation. Once there’s a hint that growth will fall short of expectations, formerly "hot" stocks can crash 30% or 40% in a day – especially if earnings were never sustainable to begin with.

In times of panic, the market tends to project the past year’s negative fundamentals into the future. For example, how much does the fact that U.S. gasoline demand is down 4% year over year matter to the value of oil stocks? It matters if gasoline demand keeps falling at a 4% annual rate over the next decade.

But you probably agree that this has little chance of happening, since oil consumption generally doesn’t fall quickly in response to higher prices. Yet most oil stocks now trade at valuations that anticipate an endless spiral in demand and prices.

I think the shortsighted fear about U.S. oil "demand destruction" is noise. It’s distracting investors from an important signal: sustainable worldwide demand and supply constraints that will determine the long-term price of oil. So you have the opportunity to take a contrarian stand, buy cheap oil stocks, and hold them as long as fundamentals stay intact and valuations stay reasonable.

Regards,

Dan Amoss, CFA
for The Daily Reckoning
December 10, 2008

Dan Amoss, CFA runs Strategic Short Report, and is a contributing editor for Strategic Investment. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings with him the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for his readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

It takes a while for the traveler to get used to Australia. He picks up the phone to call home and can’t quite figure out what time it is back in Kokomo or London; then he realizes that he can’t call anyone – they’re asleep. He reads the news and can’t figure out why the paper doesn’t report yesterday’s stock market close. Then he realizes that back in New York it still is yesterday.

We’re writing this on Wednesday morning. But it’s still Tuesday afternoon to most Dear Readers.

"I like reading the DR," said an Aussie investor last night, "but what I object to is that it is so long. Couldn’t you just save up your thoughts and put them in a simple message at the end of the week? Do you have to make us read so much to get the gist of it?"

Well, today we will keep it short. First, because less has happened – the day is still barely half over in North America. Second, because we have to rush to get on a plane to Los Angeles. And third, because we want to give long-suffering readers a break.

In that spirit, today we pass our own words through a kind of verbiage distillery and drip out the following moonshine:

Stocks down,

Gold up,

Jobs down,

Bankruptcies up,

Rally over?

Don’t think so…

Bubbles finished?

Nope, one to go…

Buy gold.

*** For those who like a little branch water with their hooch, we offer the following cogitation:

Poor Sam Zell! One of the smartest guys in real estate turned out to be one of the dumbest guys in the newspaper business.

Let’s face it, you don’t get much prestige grubbing for money in bricks and mortar. Everyone knows it’s a grimy trade, dominated by tough old birds with no heart. But newspapers! That’s a different story. A newspaper publisher is at the top of the social pecking order…because they can peck anyone they want on the editorial pages. And, heck, they don’t admit it…but they can peck on the news pages too. Editorial…news…sometimes you can’t tell the difference anyway.

So poor Sam Zell sold out his property empire at the very peak of the bull market…and used his cash to buy the Tribune – publishers of newspapers in Chicago and Los Angeles. He didn’t seem to realize that the newspapers were in trouble already – they were losing out to on-line news and opinion publishers. And now, with the falloff in advertising revenue, it looks hopes for a lot of newspapers. In small towns, for example, the local auto dealers took pages of advertising. And the local builders filled the rest of the rag.

But Sam Zell went ahead and bought the Tribune…and maybe he did some pecking…and maybe he didn’t get around to it. Because the papers have been in trouble financially since he bought them; that must have taken up his time and attention. And now they’ve gone broke.

But Zell has plenty of company. More firms are going broke every day. And others are desperately trying to stay in business by cutting payrolls. Sony, for example, announced 16,000 job losses yesterday.

We’ve done our part to help the airlines…but the industry is facing $5 billion in losses for 2008.

And Paulson has only $15 billion left of the $350 billion first draw for his deflation-fighting campaign. What happened to all that money? Well, it’s gone into the pockets of his friends and cronies on Wall Street. Bailouts…loans…nationalizations…that’s the way the new system works. The only big money being spent is money that doesn’t belong to the people spending it.

*** And the fix is in for Detroit too. At least, that’s what it says in the paper…that a "deal is close at hand."

Whew…what a relief. What would we do without GM?

We’d have to buy cars from one of the dozens of other car manufacturers in the world.

We’ve got more to say…specifically, about "balanced portfolios"…about the next big bubble…and other things. But we have no more time to say them…

So, we sign off for today…

Bill Bonner
The Daily Reckoning

Go Against the Emotional Crowd originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Bank of American Corp. (BAC), which is getting $15 billion from the U.S. government as part of the Treasury Department’s $250 billion "recapitalization" effort, is doubling its stake in state-owned China Construction Bank Corp., and will hold a 20% stake worth $24 billion in China’s second-largest lender when that deal is finalized.

PNC Financial Services Group Inc. (PNC), which will get $7.7 billion from Treasury’s Troubled Assets Relief Program (TARP), is using that cash infusion to help finance its $5.2 billion buyout of embattled National City Corp. (NCC).

And U.S. Bancorp (USB), which received a $6.6 billion capital infusion from that same rescue package, has acquired two California lenders – Downey Savings & Loan Association, F.A., a subsidiary of Downey Financial Corp. (DSL), and PFF Bank & Trust, a subsidiary of PFF Bancorp Inc. (OTC: PFFB). U.S. Bank agreed to assume the first $1.6 billion in losses from the two, but says anything beyond that amount is subject to a loss-sharing deal it struck with the Federal Deposit Insurance Corp.

While the Treasury Department’s investment of more than $250 billion in U.S. financial institutions has been billed as a strategy that will bolster the health of the banking system and also jump-start lending, buyout deals such as these three show that the recapitalization plan has actually had a much different result – one that’s left whipsawed U.S. investors and lawmakers alike feeling burned.

Those billions have touched off a high-level game of "Let’s Make a Deal," in which the biggest U.S. banks are using government money to get even bigger – admittedly removing the smaller, weaker banks from the market. And it’s also reduced the competition that’s benefited consumers and kept the explosion in banking fees from being far worse than it already is.

This all happens without any of the economic benefits that an actual increase in lending would have had. And it does nothing to address the billions worth of illiquid securities that remain on (or off) banks’ balance sheets – as this week’s Citigroup Inc. (C) imbroglio demonstrates.

In fact, Treasury’s TARP program has even managed to create a potentially illegal tax loophole that grants banks a tax-break windfall of as much as $140 billion. Lawmakers are furious – but possibly powerless, afraid that a full-scale assault on the tax change could cause already-done deals to unravel, while causing investor confidence to do the same.

One could even argue that since this first bailout wasn’t really designed to fuel takeovers and not to free up credit, the government had to roll out the $800 billion plan announced Tuesday – a move that adds still more debt to the already-sagging U.S. balance sheet.

At the end of the day, these buyout deals are bad ones no matter how you evaluate them, says R. Shah Gilani, a retired hedge fund manager and expert on the U.S. credit crisis who is the editor of the Trigger Event Strategist, which identifies trading opportunities emanating from financial-crisis "aftershocks."

"Why in the name of capitalism are taxpayers being fleeced by banks that are being given our money to grow their businesses with the further backstop of more of our money having to be thrown to the FDIC when they fail?" Gilani asked. "Consolidation does not mean that bad loans and illiquid securities are somehow merged out of existence. It means that they are being acquired under the premise that a larger, more consolidated depositor base will better be able to bear the weight of those bad assets. What in heaven’s name prevents depositors from exiting when the merged banks continue to experience massive losses and write-downs? The answer to that question would be … nothing."

In launching TARP, U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. said the government’s goal was to restore public confidence in the U.S. financial services sector – especially banks – so private investors would be willing to advance money to banks and banks, in turn, would be willing to lend.

"Our purpose is to increase the confidence of our banks, so that they will deploy, not hoard, the capital," Paulson said.

Whatever Treasury’s actual intent, the reality is that banks are already sniffing out buyout targets, while snuffing out lending – and the TARP money is the reason for both.

Fueled by this taxpayer-supplied capital, the wave of consolidation deals is "absolutely" going to accelerate, says Louis Basenese, a mergers-and-acquisitions expert who is also the editor of The Takeover Trader newsletter. "When it comes to M&A, there’s always a pronounced ‘domino effect.’ Consolidation breeds more consolidation as industry leaders conclude they have to keep acquiring in order to remain competitive."

Indeed, they’ve been quite open about it during conference calls related to quarterly earnings, or in media interviews.

Take BB&T Corp. (BBT). During a conference call that dealt with the bank’s third-quarter results, Chief Executive Officer John A. Allison IV said the Winston-Salem, N.C.-based bank "will probably participate" in the government program. Allison didn’t say whether the federal money would induce BB&T to boost its lending. But he did say the bank would likely accept the money in order to finance its expansion plans, The Wall Street Journal said.

"We think that there are going to be some acquisition opportunities – either now or in the near future – and this is a relatively inexpensive way to raise capital [to pay the buyout bill]," Allison said during the conference call.

And BB&T is hardly alone. Zions Bancorporation (ZION), a Salt Lake City-based bank that’s been squeezed by some bad real-estate loans, recently said it would be getting $1.4 billion in federal money. CEO Harris H. Simmons said the infusion would enable Zions to boost "prudent" lending and keep paying its dividend – albeit at a reduced rate.

Sounds good, right? Not so fast. During a conference call about earnings, Zions Chief Financial Officer Doyle L. Arnold said any lending increase wouldn’t be dramatic. Besides, Arnold said, Zions will also use the money "to take advantage of what we would expect will be some acquisition opportunities, including some very low risk FDIC-assisted transactions in the next several quarters."

With all the liquidity the world’s governments and central banks have injected into the global financial system, the pace of worldwide deal making is already accelerating. Global deal volume for the year has already passed the $3 trillion level – only the fifth time that’s happened, although it took about three months longer for that to happen this year than it did a year ago.

At a time when the global financial crisis – and the accompanying drop-off in available deal capital (either equity or credit) – has caused about $150 billion in already-announced deals to be yanked off the table since Sept. 1, liquidity from the U.S. and U.K. governments has ignited record levels of financial-sector deal making.

According to Dealogic, government investments in financial institutions has reached $76 billion this year – eight times as much as in all of 2007, which was the previous record year. And that total doesn’t include the $250 billion in TARP money, or other deals that Paulson & Co. are helping engineer – JPMorgan Chase & Co.’s (JPM) buyouts of The Bear Stearns Cos. and Washington Mutual Inc. (WAMUQ), for instance.

When it comes to identifying possible buyout targets, M&A experts such as Basenese say there are some very clear frontrunners.

"I’d put regional banks with solid footprints in the Southeast high on the list, and for two reasons," Basenese said. "First, demographics point to stronger growth [in this region] as retirees migrate to warmer climes – and bring their assets along for the trip. Plus, the Southeast is largely un-penetrated by large national banks. An acquisition of a regional bank like SunTrust Banks Inc. (STI) would provide a distinct competitive advantage."

There’s a very good reason that smaller players may be next: Big banks and small banks have the easiest times – relatively speaking, of course – of raising capital. It’s toughest for the regional players. Big banks can tap into the global financial markets for cash, while the very small – and typically, highly local – banks can raise money from local investors.

The afore-mentioned stealthy shift in the U.S. Tax Code actually gives big U.S. banks a potential windfall of as much as $140 billion, says Gilani, the credit crisis expert and Trigger Event Strategist editor. What does this tax-change do? By acquiring a failed bank whose only real value is the losses on its books, the successful suitor would basically then be able to use the acquired bank’s losses to offset its own gains and thus avoid paying taxes.

"While everyone was panicking, the Treasury Department slipped through a ruling that allows banks who acquire other banks to fully write-off all the acquired bank’s bad debts," Gilani says. "For 22 years, the law was such that if you were to buy a company that had losses, say, of $1 billion, you couldn’t just take that loss against your own $1billion profit and tell Uncle Sam, ‘Gee, now my loss offsets my profit, so I don’t have any profit, and I don’t owe you any tax.’ It was a recipe for tax evasion that demanded an appropriate law that only allows limited write-offs over an extended period of years."

Given these incentives, who will be doing the buying? Clearly, the biggest U.S.-based banks will be the main hunters. But The Takeover Trader’s Basenese says that even foreign banks will be on the prowl for cheap U.S. banking assets.

Basenese also believes that Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) will be "big spenders." Each will use TARP funds to help accelerate its transformation from an investment bank into a bank holding company. The changeover will require each company to build up a big base of deposits. And the best way to do that is to buy other banks, Basenese says.

"One thing [the wave of deals] does is to restore confidence in the sector," Basenese said. "It will go a long way in convincing CEOs that it’s safe to use excess capital to fund acquisitions, and to grow, instead of using it to defend against a proverbial run on the bank."

Not everyone agrees with that assessment. Investors who play the merger game correctly will do well. But the game itself won’t necessarily whip the industry into championship form, Gilani says.

"While consolidation, instead of outright collapses, in the banking industry may serve to relieve the FDIC of its burden to make good on failed banks, it in no way guarantees fewer failures," he said. "In fact, it may only serve to guarantee, in some cases, even larger failures."

Cheers,

William Patalon III
November 26, 2008

"Until today or tomorrow, the typical turkey enjoyed a fairly decent life," commented our friend Nassim Taleb, in Zurich yesterday.

Yesterday, the stock market was quiet. The Dow ended up 36 points.

Oil held at $50. Gold too…it stayed right where it was, at $820 an ounce.

But the slaughterhouses and gold mints worked overtime.

"You can understand how fraudulent most economic analysis is," Nassim explained, "just by looking the life of the turkey. The animal is fed for 1000 days…and then it is killed. So, if you plotted out the turkey’s life on a chart, it would look great for 1,000 days…each day, the food arrived reliably, and each day, the turkey gained weight. The turkeys would look around and say they were enjoying growth and a bull market. Momentum investors would see it as an opportunity. The quants would run linear regressions on the data and prove that the risk was minimal. "

Ben Bernanke would describe the turkey’s life – with no setbacks – as the product of a "great moderation." Turkey stockbrokers would assure their clients that nothing had ever gone wrong in the turkey’s life. Turkey econometricians and theorists would come up with explanations for why the turkeys’ growth would continue forever and they’d pat each other on the back for having finally mastered the "turkey cycle." Turkey politicians would run for re-election on the grounds that they had helped create a better world. And turkey economists would project further weight gains…until the turkey was the size of a hippopotamus

Then, come Thanksgiving, and all of a sudden, something goes wrong. Alas, all the turkeys’ theories, models, and conceits were for the birds.

"Rare events can’t be modeled," Nassim continued. "Because they are too rare. You can’t get a statistically reliable sample. Alan Greenspan recently explained that he ‘had never seen anything like this before.’ Well, of course he had never seen it before. It never happened before.

"Because these events are so rare, they are also completely unpredictable…and usually much worse than you can expect. Like Thanksgiving Day for the turkey."

The turkeys are getting the axe…but they’re having some revenge: Americans are getting the axe too.

Unemployment is rising sharply…and tomorrow, when Americans sit down to their turkey dinners, they will be dining in houses worth about 18% less than they were worth a year ago. Not only are their houses worth less…their values are falling faster and faster.

There’s no sign of a bottom to the housing market. In some areas – Los Angeles, Miami, San Diego, and San Francisco – the loss in housing wealth already exceeds 26% from a year earlier.

But don’t worry, dear reader. Houses are not dot.coms. And they’re not turkeys. They won’t go to zero. And they won’t disappear.

Besides, they were never financial assets in the first place. They’re just places to live. If you’re happy with your house…you don’t care what its price is.

On the other hand, if you’re not happy with your house, this is the time to start looking around. Our guess is that house prices will go down another 20-30%. Then, you will be able to get houses at very reasonable prices.. Unless you want to live in Detroit – where you’ll be able to get a house at a remarkable price.

Meanwhile, the economy itself is sinking too. GDP faded in the 3rd quarter – down 0.5%. Most likely, the U.S. economy will begin walking backwards faster too. Which means…more businesses will fail…more people will be out of work…and those people with any money in their pockets will be very careful about how they spend it…

…which will, of course, make things worse.

All this is a natural, normal response to a credit bubble. It gets bigger and bigger – and then it blows up. Loans are made…and then they are collected. Mistakes are made…and then they are corrected. People do stupid things…and then they pay for them. People go mad on the way up…then, they go mad again on the way down. What could be simpler?

But if you think the feds are going to stand still and let something natural happen, you have not been reading the papers. They’re "pulling out all the stops" to try to prevent the correction. More below…

*** So far, the feds’ efforts have been futile. But we have little doubt that they will get the hang of it eventually. If there is one thing the feds can do it is inflate the money supply. Ben Bernanke stakes his reputation on it.

And here is Thomas L. Friedman explaining what is needed:

"…a massive stimulus program to improve infrastructure and create jobs, a broad-based homeowner initiative to limit foreclosures and stabilize housing prices, and therefore mortgage assets, more capital for bank balance sheets, and most importantly, a huge injection of optimism and confidence…"

Friedman is the voice of the masses. But the intellectuals agree. Bloomberg reports:

"’You want to do everything you can when you’re facing the threat of a deflationary breakdown of the economy,’ says Michael Feroli, a former Fed official who is now an economist at JPMorgan Chase & Co. in New York. He sees the central bank cutting the overnight lending rate to zero in January and holding it there throughout the year."

"Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson are being forced to pull out the stops because the extraordinary actions they’ve taken so far have failed to gain much traction. Credit markets are collapsing, stock prices are plunging and the world economy is sinking into a recession."

"The biggest mistake Obama could make," says Yale economist Jeffrey Garten, "is thinking this problem is smaller than it is. On the other hand, there is far less danger in over-estimating what will be necessary to solve it."

Yeah…go ahead and err on this side now…. Why not? You erred on the other side. That is about the depth and breadth of thinking on the issue – at least from the people who never understood what the problem was…and now offer to solve it.

And it was to one of these same hacks whom Obama has turned for his Secretary of the Treasury – Timothy Geithner. Here is another Hank Paulson. Unlike Hank, he did not work on Wall Street. Instead, he was supposed to be keeping an eye on Wall Street – as head of the New York Fed. "He was in the room," when all the bailouts and busts happened, said one Wall Street pro. AIG, Bear, Lehman, Citigroup – he was in on them all. And he was at least peeping through a keyhole when Wall Street was enjoying its wild party. He saw the deals go down…the leveraged debt…the private equity buyouts…the subprime razzle-dazzle…the quants…the bonuses.

We don’t recall a single word of warning. But then, he’s a young guy…maybe he’s learned something.

But we have a pretty strong hunch he’ll be at the Treasury Department not to further his education…but to play his role in the developing tragedy. He’s meant to try to stop the correction. Rather than examine his lines carefully to see if they really make sense…he’ll speak the speech given him. "Stimulus," he will say. "Protect jobs…save homes…avoid financial meltdown." he has heard them before. He will say them again. And why not? Almost everyone wants to hear them. They all want bailout. Almost everyone wants to be saved. Almost everyone wants to duck the bill collector…and stop the hangman.

We all have to play our roles, dear reader. We are all turkeys…waiting for the axe.

*** The way, for now, to avoid getting flattened by the Big Bang Bailout, soon to be ignited by Mr. Obama, is to buy gold. But how? This week, we got word that that Perth Mint has had to shut it doors.

This, from the Australian:

"FEARS of the unknown long-term effects from the global financial crisis have sparked a new gold rush.

"With retail and wholesale clients around the world stocking up on the precious metal, the Perth Mint has been forced to suspend orders.

"As the World Gold Council reported that the dollar demand for gold reached a quarterly record of $US32 billion ($50.73 billion) in the third quarter, industry insiders said the race to secure physical gold had reached an intensity that had never been witnessed before.

"Perth Mint sales and marketing director Ron Currie said the unprecedented demand had

forced the Mint to cease orders until January, with staff working seven days a week, 24-hour days, over three shifts to meet orders.

"He said Europe was leading the demand, with Russia, Ukraine, Middle East and US all buying — making up 80 per cent of its sales. One European client purchased 30,000 ounces for $33 million.

"We have never seen this before and are working right at capacity. And we are seeing it from clients in the shop buying one ounce, right up to 30,000 ounces from overseas clients," Mr Currie said.

"Robert Jaggard, manager of bullion and rare coins dealer Jaggards, said business had picked up strongly and he expected it to increase further.

"All around the world there has been a heavy run on physical gold and there is a shortage of supply," he said.

Until tomorrow,

Bill Bonner
The Daily Reckoning

Billions in Bank Rescue Funds are Fueling Buyouts, Instead of Lending originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Until recently, average Americans were only dimly aware that there were two types of banks – the commercial banks nearby and the major investment banks located in faraway New York. Understanding the bank where they conducted business, with people they knew, was enough. The big, impersonal Wall Street banks – which dealt in higher-risk investments with potentially higher rewards – were for companies and the very rich.

While ordinary citizens thought little about the distinctions among banks, the government did. Seventy-five years ago, as the Depression deepened, lawmakers were desperately trying to determine the causes of the crisis (read, looking for scapegoats). Some of the things they found were conflicts of interest and opportunities for fraud linked to the mixing of commercial and investment banking.

Congress decided to erect a "wall" between commercial and investment banking, and so passed the Banking Act of 1933, usually referred to as the Glass-Steagall Act. Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to protect depositors in commercial banks, and it forbade commercial banks to underwrite securities or act as stockbrokers or dealers.

Glass-Steagall remained in force for six and a half decades, although various deregulatory measures and changes in exchange rules chipped away at it. Notably, in 1970 a rule excluding public companies from membership in the New York Stock Exchange was dropped. The last major private institution, Goldman Sachs, went public in 1999. This allowed investment banks to sell stock to any potential investor and greatly expand their capital base.

Over the last two decades of the 20th century, the financial industry lobbied vigorously for the repeal of Glass-Steagall and, in 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.

With one stroke of a pen, commercial bankers could begin turning their loans into investment products. (Glass-Steagall had prevented them from selling debt-backed securities for which they were the underwriters.) And Wall Street investment banks were suddenly in the mortgage business. It would prove to be a marriage made somewhere significantly south of heaven.

We’re not fans of government regulation, but a deregulated marketplace carries with it certain imperatives. It functions as it should only in the absence of both criminal and boneheaded behavior. We can erect oversights meant to prevent the former and laws to punish it after the fact. But all the regulation in the world won’t do much about the latter, since both market traders and the regulation itself may be boneheaded.

The biggest factor here was the removal of Glass-Steagall prohibitions, but there were two other important tweakings.

The Commodities Futures Modernization Act of 2000 transformed the new mortgage-backed securities into a commodity, enabling them to be traded on futures exchanges with little oversight by any federal or state regulatory body.

Completing the trifecta, the Securities and Exchange Commission in 2004 waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. But under the new regulations, five companies – Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley – were granted an exemption, which they promptly used to lever up 20, 30, even 40 to 1.

Just as Congress was repealing Glass-Steagall, the tech stock bubble was inflating beyond sustainability. It would soon be pricked, ushering in a brief recession during which investors began the hunt for the next big thing.

Well, how about housing?

Back in 1977, Congress passed the Community Reinvestment Act, which had the goal of extending homeownership to the largest possible pool of Americans. Over the next 25 years, legislative supplements, a robust housing market, and aggressive government enforcement of "fairness in lending" combined to weaken bank standards of who did or didn’t qualify for a loan.

But that was just the beginning. In an effort to end a recession in the new century’s first years, the Greenspan Fed reduced interest rates to near nothing and poured liquidity into the financial markets. At the same time, capital that had fled the stock market was looking for action.

The commercial banks – and independent mortgagors like Countrywide Credit – were awash in cash. They started lending it, and every borrower’s credentials were deemed excellent, even those with low income, bad credit, and no money for a down payment.

The perfect storm was building. But at first, boy, did things ever look rosy. The country’s homeownership rate – 62.1% in 1960, rising to only 64.1% in 1994 – shot up to 68.9% by 2006.

As homeowner mania seized hold of the public imagination, people began treating their homes as ATMs. If they needed cash, they borrowed against their growing equity. Real estate speculators flipped houses like crazy. Why not, when there’s no risk? Housing prices only head in one direction, up, up, up, right?

It sure looked that way. The yearly average median price of an existing home went from $23,000 in 1970, to $62,200 in 1980, to $97,300 in 1990, to $147,300 in 2000 and crested at $221,900 in 2006. Astonishingly, despite recessions in the early ’80s and early ’00s, there wasn’t a single down year for housing in all that time.

However, in 2007 housing became the latest bubble to burst, pricked by unrealistic prices, overbuilding, and the retreat from ultra-low interest rates. Concurrently, as house prices finally began to drop, a whole bunch of those no- or low-interest loans began to reset.

Despite the well-earned reputation of some Wall Street high rollers, bankers tend not to be a reckless lot, nor financial dunces. In general, they would rather deploy a large amount of capital into a safe, low-yield investment than put a small amount of capital into something with very high risk.

With the new environment, however, the game changed. Commercial bankers found themselves making loans to shakier and shakier recipients, while at the same time, the investment banks and their clients were clamoring for new investment products.

So bankers did what any conservative person would do. They hedged their bets. They bundled up their loans and sold the packages to the investment banks. The outcome was essentially the mortgage business being uprooted from the commercial banks and transplanted into the investment houses, which have far less restrictive requirements about reserve capital, far fewer limits on the buying and selling of securities, and far less regulatory oversight.

The investment banks did not set out, of course, to become landlords. They just wanted some product to sell for which there was a ready market. As capitalist ingenuity collided with profit motive, they found there was no shortage of products that could be created; the mortgage bundles were sliced, diced, and repackaged into a bewildering array of securities, like structured investment vehicles (SIVs), collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and on and on.

The extent of the slicing and dicing into what financial chefs refer to as tranches was such that the original mortgage might be tossed from buyer to buyer, or even itself split into parts. Each time a package was put together and sold, the seller stretched to get top dollar for each tranche, requiring the underlying assets to be risk-rated and then assigned real-world value. In the end, rating services had little idea what they were rating (we’re being charitable here), and buyers had no idea what their purchase was really worth.

And always lurking in the background was the possibility that defaults on the mortgages supporting the entire process could have a profound ripple effect, given that these products became increasingly leveraged. Knowing this, traders invented credit default swaps (CDSs), those gnarly little creatures that morphed into Godzilla after 2004.

CDSs are an insurance policy, a way of dealing with fear, and a device for attenuating the risk inherent in trading products one may not fully understand. Those buying the protection pay an upfront amount and yearly premiums to the protection sellers, who agree in return to cover any loss to the face value of the security. The result is a private, two-party contract, devoid of regulatory oversight.

There are a bunch of nasty horseflies in this particular ointment. For one, the holder of that security (who is now "protected" by a CDS) might turn around and sell it to a third party, who might himself insure and resell it, and so on, creating an impossibly complex chain of ownership and obligation. Additionally, the CDS itself can be traded over the counter. Furthermore, any of the underlying assets might also get partitioned into different tranches, adding to the confusion. And finally, short sellers can work on just about any joint in the structure.

And here’s the really big rub. Suppose the party providing the initial insurance protection – having already collected its upfront payment and premiums – doesn’t have the money to pay the insured buyer when a default occurs. Or suppose the "insurer" goes bankrupt. In either instance, the buyer who thought he was protected finds himself left naked and alone.

However, that possibility seems not to have been considered as the financial world created an interlocking system of derivatives that not even a Cray supercomputer could sort out. The only certainty: it was an arrangement that depended on a robust economy and rising house prices.

Except, of course, things didn’t work out that way.

When the housing slump hit, defaults in the relatively small subprime sector (less than 20% of mortgages) started a chain reaction that raced through the derivatives market, the effects compounding geometrically, until finally the world financial structure was facing collapse.

To be continued, tomorrow…

Doug Hornig
for The Daily Reckoning
November 12, 2008

Protecting your assets is not just a buzzword anymore, it’s mandatory if you want to keep yourself and your family financially safe in these tough times…which will only get tougher in the near future.

Poor Mountain House, California.

The town is underwater, reports the International Herald Tribune. Nine out of ten houses are worth less than their mortgages. There are some 1,856 mortgaged properties in the zip code area of Mountain House. Only 209 of them have any positive equity.

How the screw turns! Is this the "ownership society" promoted by the Bush Administration? Now, people own less than ever!

There are said to be almost 8 million houses with negative equity in the United States.

Of course, people own a lot less in stocks than they did a few months ago too. Worldwide, stocks have shucked off about $28 trillion worth of value.

Poor…rich…middle class – everyone has been hit. The marginal homeowner has already been tossed out onto the street. And now comes word that an extraordinary resort in Montana, designed for the super-rich, has gone bust.

"Where did the money go?" asked Montana governor Brian Schweitzer, speaking of Tim and Edna Blixseth’s swanky resort in the Gallatin mountains. Of course, he might have been referring to almost anything – the Russian stock market, the oil market, the mining industry, Wall Street…everywhere you look…from trailer parks to Park Avenue…poof!… the money’s disappeared.

The oil price is signaling more doom and gloom ahead too. It slipped below $60 yesterday…

… And now, in the art market, "prices finally plunge," reports the Daily Telegraph. An auction in New York of Impressionists and modern art was supposed to bring in $800 million. Instead, it barely fetched half that much – only $470 million by Friday night. Some lots didn’t sell at all. Only 60% of the artworks sold…at prices most about 30% below estimates.

Let’s take a quick look at how these losses are transformed from financial problems into economic problems.

"The domino effect," is how today’s Independent describes it.

On the cover is the photo of a "news agent," someone who runs a little shop selling magazines, newspapers, snacks, and so forth.

"Hit by falling sales, he decided not to repair his window. Thousands of other people did likewise. So Chemix, a chemical company in Stockport that supplies the building trade, went out of business – with 60 people losing their jobs. These are the sort of tiny decisions that lay behind the loss of 5,000 jobs yesterday. And this is why experts predict 2,000,000 people [in England] will be unemployed by Christmas."

In the United States, the figure is 10 million.

So great is America’s economic squeeze that people can’t even afford a cup of coffee. Starbucks reports that its profits are off 97%. Not much left.

And, yesterday, General Motors shares fell to a new low of $2.79. The last time you could have bought the automaker so cheaply was in 1937. Back then, it would have been a good investment. The U.S. auto industry was on the way up. Now, Detroit is going down – hard. In the town itself, you can buy mansions for pennies. Empty warehouses are available almost for free. But who wants them?

Investors fear GM may run out of cash within weeks and be forced into bankruptcy. Nancy Pelosi says a special lame duck session of Congress may be called to get emergency cash to Detroit.

Of course, that’s they way the feds do business – always trying to prop up failures…trying to block progress…trying to delay the process of correction. In short, they’re trying to stop "nature’s delight" – change.

Meanwhile, the Dow fell another 176 points. The panic is gone, but the retreat continues. The Dow stood at 8,694 at the close of business yesterday.

At these prices, many investment pros are ready to get back in. Stocks are a bargain, they say. You get more value for money than you got in years, they point out. "Both my money and my mouth say the same thing," adds Warren Buffett: "Buy equities."

Take a look at Starbucks, for example. It used to be such a growth company that shares traded at 50 times earnings. Now you can get them for 12 times earnings. But with collapsing earnings…the share price could fall a lot more.

The stock market bulls aren’t necessarily wrong. But we announced a "Trade of the Decade" in 2000 – sell stocks, buy gold. The decade has a few more months to run, so we’ll stick with it. At the beginning of this decade you could get about 40 ounces of gold for a unit of the Dow stocks. Now, you barely get 12. If you’d done the trade and stuck with it, you’d be up about 200%.

Besides, it looks to us as though the Dow is going to drop below 5,000 before this is over. Dividend yields have risen to almost 4%. When the dividend yield reaches 6%…and you can trade one ounce of gold for the entire Dow…call us.

*** A few months ago, we wondered what the surprise would be. Mr. Market always has some tricks up his sleeve. What must happen always happens, but never as you expect.

So when stocks started to slide and people began talking about a ’soft landing for global growth,’ we wondered where the surprise would be.

Now we know. The downturn has been much more violent than almost anyone imagined. And it’s beginning to look as though the long-term damage could be much greater too.

Remember, a correction is equal and opposite to the deception that preceded it. Where was the deception of the boom years most concentrated? In two places – the United States and China.

Americans believed they could live beyond their means forever. China believed it could get rich by selling more and more manufactured items – even though its major customer couldn’t pay.

You’d expect the resulting suffering to be equal and opposite to the aforegone enjoyment too. That is, those who lived highest on the hog should fall the farthest, no? And those who benefited most from selling to these people should lose most money.

So far, we’ve seen the beginnings of these redressments. But probably only just the beginning. Some people in America have lost their houses… some have lost their jobs. Spending has begun to fall. But the typical American continues to enjoy a standard of living that most of the world’s people cannot afford – including most Americans.

It will get worse. The third quarter showed the biggest decline in consumer spending in 28 years.

This is a "balance sheet recession," remember? Consumers, businesses, investors – all need to pay down debt and build up savings. This will mean a huge turnaround for everyone – especially consumers. They have to reduce their standards of living dramatically in order to save money. And especially the baby boomer consumers – who also have to sock away some cash for retirement.

Saving went out of style in the ’90s…but it’s becoming very popular, very fast. We’re going to see national savings rates rise…back to nearly 10%…and maybe beyond. This is exactly what consumers need to do. Consumers need savings. But the trend is murder on a consumer economy. A 10% savings rate means about $1.3 trillion in money that is NOT spent every year. (That’s why Obama is going to have a $2 trillion budget deficit…more on that tomorrow.)

And here comes the bad news from the Wall Street Journal: "Retail Losses Sap a Jobs Safety Net."

We’re not sure how you sap a safety net. But for millions of people, when budgets got tight, someone could always go to work as a clerk in a retail shop. The money was poor, but at least it was money. And it filled in the gaps. For retired people…students…part-time working spouses – retail employment was always there…a fallback position…a "safety net."

But with sales collapsing, the safety net is on the hard ground. The complaint of working stiffs used to be that "good jobs" were hard to find. You could always find a ‘bad job’ – flipping burgers or stocking shelves. But jobs with health benefits and union wages were few and far between. Now, even bad jobs are getting hard to find.

*** The other big loser will be China. Here, too, investors have suffered huge losses already. But China is still growing…still producing beaucoup stuff for people who no longer have the means or the desire to buy it.

"No one should underestimate Asia’s exposure to this crisis," writes Richard Duncan in Far Eastern Economic Review. "At best, Asia is facing a severe recession. September 2008 may mark the end of the era of export-led growth, rather than merely the beginning of a more typical global recession. Asia’s export-led economic model is just as threatened as the Anglo-Saxon model of highly leveraged capitalism."

Until tomorrow,

Bill Bonner
The Daily Reckoning

Hell, Meet Handbasket, Part I originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

After an historic election and inauguration, president-elect Obama will enter office with a huge list of challenges. These challenges – from a contracting economy to looming energy supply shortfalls – will undoubtedly restrict his agenda.

Let’s hope Obama recognizes the need for incentives, profits, and capital investments in the economy. The economy cannot be taxed and regulated without potentially severe consequences. Former Fed Chairman Paul Volcker (and the last Fed chairman to provide adult supervision for the banking community) is an Obama adviser. So Obama should be apprised of the consequences of Carter-era deficit spending and money printing.

At the very least, Obama must act as a check on the potential for a Democrat-dominated Congress to turn a recession into a depression.

For example, some in Congress are floating a proposal to steal your 401(k), sell the proceeds, and invest in "government-guaranteed" retirement accounts. The only thing this Marxist idea would guarantee is a depression. Call or write your congressman if you feel that your 401(k) is in danger. We shouldn’t allow them to steal more from prudent savers than they already have.

Keep in mind that presidencies rarely resemble campaigns. President Bush campaigned on limited government and a humble foreign policy, and we got the opposite. To top it off, we had the illusion of real growth, with credit and housing bubbles that led to the greatest misallocation of resources in history.

The free market has been falsely accused for this financial crisis. But the free market didn’t get us here; a combination of government spending and crony capitalism did. Much ink is wasted on how we need to re-regulate Wall Street, but the fact is that the problem would never have grown so large without agency conflicts and a banking system built upon on a foundation of paper money.

The agency conflict on Wall Street is the mentality of "heads I win, tails you lose." CEOs, traders, and mortgage-backed security factories were paid more for taking more risk. So it shouldn’t surprise us that they overdosed on leverage to magnify returns, without considering risk.

Performance pay should be based on creating long-term shareholder value, not on meeting next quarter’s earnings estimate. A good place to start would be bonuses in the form of restricted stock that does not vest for 10 years. I doubt Lehman would have blown up if employees were paid modest salaries with the potential for sizeable ownership stakes in the future.

If every employee were paid partially in restricted stock of his or her company, even a small amount, most agency conflicts would be eliminated.

Much of our current mess resulted from totally complacent, incompetent boards of directors. Carl Icahn has good ideas for how this can be addressed without excessive regulation. Icahn explains how most corporate boards behave like government bureaucrats in this post. In my view, we need an economy in which everyone acts like owners, rather than CEO pillagers or union extortionists. For example, look at how decades of management and union looting brought General Motors to its state of current crisis.

A banking system built upon on a foundation of paper money also contributed to this crisis. The Treasury and Fed allowed institutions to grow "too big to fail." Without taxpayer subsidies (i.e., Fannie and Freddie – two of the worst crony capitalist institutions in history) and the subsidy of Fed rate cuts, housing prices would have kept growing in step with household income. Instead, house prices went to the moon. Precious capital was thrown into a black hole when mortgage-underwriting discipline went out the window and homebuyers deluded themselves with bubble psychology.

As Albert Einstein noted in the quote above, our problems "cannot be solved by the same level of thinking that created them." If the federal government proposes "solutions" to this crisis with the same type of thinking that got us here, we could be in for a very long period of economic pain. America’s status as a destination for foreign capital is at stake.

If the new government fails to act wisely and understand how we got here, the only "government guarantee" we’ll have is depression.

Regards,

Dan Amoss
for The Daily Reckoning
November 11, 2008

P.S. Our investing odds are that this bear market rally will last a little while longer. I’m amazed at the long list of very oversold stocks, so I may have a new call option idea for you. I’m building a list of new short ideas as well. For my Strategic Short Report readers, get ready for a new recommendation to hit your inbox at any point in the coming weeks.

Dan Amoss, CFA runs Strategic Short Report, and is a contributing editor for Strategic Investment. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings with him the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for his readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

Today, on the 11th day of the 11th month at precisely 11AM, London will fall silent. We will be asked to remember our war dead.

This moment marks the time 90 years ago when the guns ceased firing on the Western Front. Soldiers on both sides hesitated…wondering if it were really true. After four years of trying to kill each other – leaving 40 million dead – all of a sudden, the heads of state decided they’d had enough. Slowly, cautiously, the French "poilus"…the English "tommies"…the American "doughboys"…and the German "fritzes…huns…krauts" crawled out of their trenches. They walked across no-man’s-land and greeted their opponents. They shook hands. They traded tobacco. It was over.

"What was that all about?" asked colleague Simon Nixon last night. "I’ve been reading about the war, trying to understand it. But no one seems to understand it at all. What caused the war? Who wanted war? No one can tell you."

Before the war began, Europe and America enjoyed the greatest burst of prosperity in human history. Thanks largely to the British Empire, trade had been globalized. A man of means, in London, Paris or New York, could order his shoes from a cobbler in Italy, his tea from India, his plates from China, his watch from Geneva, his whiskey from Scotland and his hunting rifle from Germany.

This trade meant that a war was in no one’s commercial interest. A popular author and lecturer told audiences that war was a thing of the past; that it was impossible for modern countries to go to war with each other since they depended so much on each other’s production.

But there’s always more to the story.

As it turned out, the sky fell in 1914…and it kept coming down for the next 31 years. In last week’s recitation of all the calamities that befell the generation of ‘14 – war, depression, influenza, bankruptcy, hyperinflation – we left out one, the Dust Bowl. The poor Okies got it all.

What can we learn from this? That bad things happen – even things you thought were impossible. And that when things do go bad…they can go bad in a big way.

What can go wrong now? A lot…things we can’t even imagine.

But let’s go from the future back to the past…well, at least back to yesterday. When the sun rose over Tokyo investors hope rose with it. China came out with a big bailout program of its own over the weekend – a plan called a "Social Stabilization" program, in which the government will spend more than half a trillion dollars to try to avoid a revolution. We’re just guessing that that is what is disturbs policymakers’ sleep in the Middle Kingdom – the horror of hundreds of millions of desperate, jobless Chinese.

Hope carried most of the day. Asian equity markets rallied – boosted by the Chinese bailout plan. But then, the bad news kept coming…and by first light in New York, hopes were already fading. At the end of trading, stocks ended mixed in Asia and the Dow fell 73 points in Manhattan. Oil closed at $62 yesterday, but seems to be slipping towards $60 this morning. Gold is trading at about $745 – after rising yesterday.

We’ve already seen things begin to go wrong. Unless the next 45 days bring a remarkable bounce, this year will be the worst year for the stock market since 1937. Trillions of dollars has been lost…which has already caused a major change in the way people think. In a matter of weeks, the dominant emotion has shifted from greed to fear.

You’ll remember, the Bush administration worked hard to make people fearful. They came up with those preposterous "threat levels," trying to convince the mob that it was in constant danger.

Now, the mob actually feels in danger – in danger of losing its jobs and houses. Fake fear has given way to real fear. So, the new administration will turn away trying to create an atmosphere of fear to trying to give people confidence.

It’s the "End of the National Nightmare," says TIME magazine. No more torture. No more ‘threat levels.’ No more suspected terrorists working behind the counter at Burger King. Terrorists? Who cares about them? The danger is now real…and right out in the open. Everyone is running scared.

And so, in the national narrative, one cockamamie bamboozle takes the place of the one that went before. What we had to fear before was a worldwide terrorist assault on our freedom. Now, we gladly give up our freedom, in the hope that it will keep us from losing any more money. Now, when the feds come a knockin’, we all open the door and invite them in. Because we need them to give us money…to bankroll our banks…to bailout our auto industry…to provide financing for our homes…to save our economy… and our jobs…

Imagine that just a few short months ago we were naïve enough to think that people should look out for their own finances…that free market should decide which businesses survive and which fail…that buyers and sellers should set prices for assets…and that capitalists should finance their own banks and insurance companies with their own money.

Now, we’re so much smarter! Now, we include the government in our prayers: may it be guided by wise and worthy men…may it keep the bread baking and the circuses performing. And why not count on the government? Remember, the only thing we have to fear is fear itself.

*** One thing is sure. Now, nobody likes George W. Bush…and nobody likes Wall Street. The two are probably going to be punished in the months ahead – with higher taxes and more restrictions on the rich…and a thorough cleanout of the Bush administration and all its works.

In that regard, we still have not heard our Sovereign Hotline phone ring. And we presume that it is all the world’s heads of state who are not calling – George W. Bush included. Still, we offer some advice to poor George: watch your back. Some smart lawyer is probably working up a ‘war crimes’ case against you. Of course, you’ve got it coming… But remember what happened to Pinochet; he went to London for some medical work and they clamped him in prison. After Obama moves into the White House, you might want to go down to that ranch in Paraguay…pay off some of the local politicians…and stay there.

Meanwhile, we have some advice for Obama to cut taxes. Cut them so much it takes the world’s breath away. And then, talk up your Big Bang Bailout as if it were equivalent to WWII. Next year, borrow $2 trillion to rebuild the nation’s infrastructure…put in decent railroads, for example.

Here’s what will happen: the average person is desperate for cash. And he’s desperate to rebuild his balance sheet – paying off debt and adding savings. The tax cut will help him do that. And it will allow the savings rate to go back to where it was before Greenspan’s bubble years – around 10%…or about $1.3 trillion. That cash will go mostly into U.S. Treasury debt…the only place where it is believed to be safe. In other words, if you cut taxes, the money will come back to the U.S. government, allowing the bailouts and spending to continue.

Of course, at some level the whole thing is just a massive humbug. All you’re really doing is replacing private spending with government spending. But that’s what you want to do anyway. This is just a way of gaining more government control over the economy while appearing to save people from a depression.

Will it actually stop a depression? Yes…and no. The key thing is that Americans’ wealth…their standards of living…must come down. The president’s objective should be to allow them to fall without revolution, or national despair. Under this plan, standards of living will fall – except for those few who are likely to get a sweetheart deal to build a train line…or actually ride a train to work. But the numbers will look fairly decent. There will be jobs. There will be economic activity. Confidence will be restored – albeit of a phony sort. It will look a bit like the U.S. economy during WWII…when living standards fell but savings increased. It will look good to most people. And you, Mr. Obama, will go down in history as one of our greatest presidents.

*** "Uniquely in this global age, it is now in our power to come together so that 2008 is remembered not just for the failure of a financial crash that engulfed the world but for the resilience and optimism with which we faced the storm, endured it and prevailed," said Gordon Brown in his speech on Monday evening.

"…And if we learn from our experience of turning unity of purpose into unity of action, we can together seize this moment of change in our world to create a truly global society."

"My message is that we must be: internationalist not protectionist; interventionist not neutral; progressive not reactive; and forward looking not frozen by events. We can seize the moment and in doing so build a truly global society."

Ai yi yi…

*** And this from our Pittsburg correspondent, Byron King, just back from South Africa:

"SA is a fascinating place. It’s a ‘destination’ in some respects, but only if you are prepared to be challenged in many ways. Particularly (for me at least) I had to spend a lot of time wrestling with severe moral ambiguities as I observed a society in massive transition. Rich & poor, past & present, dangerous in many ways….

"Meanwhile in the US of A, we have a nation in which it is common for some individuals and groups to believe they are have-nots, when in the larger reality they are among the cream of the world’s haves. And after decades of effort, we may yet succeed in turning the world’s greatest have-nation into a have-not land. I know that we’re working on it. Spending ourselves broke. Then borrowing to spend ourselves broke some more. Terrible rates of saving and investing. Transferring wealth from the future to now, and [wasting] it away. That, plus we are ‘out of army’ with which to police the world.

"The only thing that’s missing is the huge military disaster that eventually befalls an empire in decline. Rome’s Varus losing an entire army to the German hordes… Russia losing its fleet to the Japanese at Tsushima in 1905… More recently, in 1940 the British battleship Hood blowing up and sinking in three minutes under the guns of the Bismarck…. The French at Dien Bien Phu… The good Gen. Petreaus salvaged Iraq for the US. But what comes next? Eventually, something comes next. Something always comes next."

What comes next, dear reader…? We don’t know…but we’ll find out.

Until tomorrow,

Bill Bonner
The Daily Reckoning

Government-Guaranteed Depression? originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

One of Obama’s prime campaign planks has been his promise to mercilessly raise taxes on the "rich," a group initially defined as those making more than $250,000 per year. This was later dropped to $200,000 per year, and more recently has been defined as those Americans making more than $150,000 annually.

Setting aside the precipitous downward slide in the definition of "rich," there is ample reason to suspect that Obama’s tax changes portend much higher, if not confiscatory taxes on the most productive Americans. Obama has strongly argued for higher taxes as a way of employing government to alter the pre-tax distribution of income, which he believes has concentrated too much of the gains from productivity in recent years in the hands of the very rich.

He seems to think that the "very rich" are a closed caste of more or less fixed membership, which changes little from year-to-year. This figures in his concept of "fairness," which supposes that it is perfectly just to burden a small fraction of the population with a majority of the costs of running the Federal government. This was detailed in a New York Times article on "spreading the wealth" by David Leonhardt. He wrote of Obama:

"He would then pay for the cuts, at least in part, by raising taxes on the affluent to a point where they would eventually be slightly higher than they were under Clinton. For these upper-income families, the Tax Policy Center’s comparisons with McCain are even starker. McCain, by continuing the basic thrust of Bush’s tax policies and adding a few new wrinkles, would cut taxes for the top 0.1 percent of earners – those making an average of $9.1 million – by another $190,000 a year, on top of the Bush reductions. Obama would raise taxes on this top 0.1 percent by an average of $800,000 a year. ‘It’s hard not to look at that figure and be a little stunned. It would represent a huge tax increase on the wealthy families. But it’s also worth putting the number in some context. The bulk of Obama’s tax increases on the wealthy – about $500,000 of that $800,000 – would simply take away Bush’s tax cuts. The remaining $300,000 wouldn’t nearly reverse their pretax income gains in recent years. Since the mid-1990s, their inflation-adjusted pretax income has roughly doubled.’

"To put it another way, the wealthy have done so well over the past few decades, with their incomes soaring and tax rates plummeting, that Obama’s plan would not come close to erasing their gains. The same would be true of households making a few hundred thousand dollars a year (who have gotten smaller raises than the very rich but would also face smaller tax increases). As ambitious as Obama’s proposals might be, they would still leave the gap between the rich and everyone else far wider than it burdensome on the young entrepreneur who was making his first millions as it would on the aging plutocrat who actually had enjoyed the prosperity of the past-quarter century since Reagan cut marginal tax rates."

An October 13 editorial in The Wall Street Journal clarifies the mysterious arithmetic of Obama’s sweeping claims to cut income taxes for millions who currently have no income tax liability and pay no taxes:

"For the Obama Democrats, a tax cut is no longer letting you keep more of what you earn. In their lexicon, a tax cut includes tens of billions of dollars in government handouts that are disguised by the phrase ‘tax credit.’ Mr. Obama is proposing to create or expand no fewer than seven such credits for individuals:

"- A $500 tax credit ($1,000 a couple) to ‘make work pay’ that phases out at income of $75,000 for individuals and $150,000 per couple.

"- A $4,000 tax credit for college tuition.

"- A 10% mortgage interest tax credit (on top of the existing mortgage interest deduction and other housing subsidies).

"- A ’savings’ tax credit of 50% up to $1,000.

"- An expansion of the earned-income tax credit that would allow single workers to receive as much as $555 a year, up from $175 now, and give these workers up to $1,110 if they are paying child support.

"- A child care credit of 50% up to $6,000 of expenses a year.

"- A ‘clean car’ tax credit of up to $7,000 on the purchase of certain vehicles.

"Here’s the political catch. All but the clean car credit would be ‘refundable,’ which is Washington-speak for the fact that you can receive these checks even if you have no income-tax liability. In other words, they are an income transfer – a federal check – from taxpayers to nontaxpayers. Once upon a time we called this ‘welfare,’ or in George McGovern’s 1972 campaign a ‘Demogrant.’ Mr. Obama’s genius is to call it a tax cut.

"The Tax Foundation estimates that under the Obama plan 63 million Americans, or 44% of all tax filers, would have no income tax liability and most of those would get a check from the IRS each year. The Heritage Foundation’s Center for Data Analysis estimates that by 2011, under the Obama plan, an additional 10 million filers would pay zero taxes while cashing checks from the IRS.

"The total annual expenditures on refundable ‘tax credits’ would rise over the next 10 years by $647 billion to $1.054 trillion, according to the Tax Policy Center. This means that the tax-credit welfare state would soon cost four times actual cash welfare. By redefining such income payments as ‘tax credits,’ the Obama campaign also redefines them away as a tax share of GDP. Presto, the federal tax burden looks much smaller than it really is."

After all the sloppy definitions are parsed, one point remains clear. The top 5% of U.S. income earners, who presently pay 60.14% (2006 figures) of all income tax, are destined for a huge federal tax increase under Obama.

One of Obama’s specific proposals is to raise the capital gains and dividend taxes to 25%, which will sharply increase capital confiscation as increasing percentages of "gains" will reflect inflationary depreciation of the currency. In the U.S., an investor must pay tax on the difference between the sales price of an asset and it purchase price, with no adjustment for inflation. Consequently, when the tax rate and inflation are high, a large portion of the "capital gain" is illusory. Any asset that appreciates by less than the rate of inflation will result in its owner losing purchasing power and having to pay taxes on the illusory gains. At Obama’s higher tax rates, (he has suggested that capital gains and dividend taxes should be hiked to as much as 25%,) capital confiscation would result from modest levels of inflation.

And the Great Credit Crunch implies that inflation will be far higher than in recent experience.

Setting aside whether it is moral or equitable to force a small fraction of the population to essentially pay for the whole cost of government, much of which entails the shuffling of checks to purchase votes of various aggrieved groups, there is a bigger question. Can it be wise for the whole fiscal regime to stand on the shoulders of a small group, like a pyramid tottering on its point, so that any tribulation which undermines the prosperity of those who pay would promise to bankrupt the state?

It is a worthwhile question to ask if you have considerable assets. In light of the worldwide credit crunch, which has deflated assets of all kinds, the prospect of burgeoning prosperity at the magnitude required to enable one-in-20 Americans to become "Super Rich" benefactors of Big Government is vanishingly small. There won’t be enough rich people to fill the role assigned to them in Obama’s scheme. The result to be expected, in addition to confiscatory taxation, is a dramatic shortfall of revenues. This, in turn, implies surging deficits and deficit financing requirements that will rapidly swamp the capacity of the Treasury to borrow.

Regards,

Jim Davidson
for The Daily Reckoning
November 05, 2008

James Dale Davidson has enjoyed astounding personal success founding new companies in a variety of industries. A graduate of Oxford University, Mr. Davidson is also a renowned venture capitalist and the author of bestsellers such as Blood In The Streets and The Great Reckoning.

As Dick Tuck put it, after losing a California State Senate election:

"The people have spoken…the bastards."

America’s voters spoke yesterday. And they said, "Give us Obama."

And it came to pass that the man called Obama was given unto them.

"America is a place where all things are possible," said the man himself in his victory speech.

And yes, it is possible for a half-black man to be elected. But no, all things are not possible. It is not still not possible to get rich by spending money. Nor is it possible to save a man from too much debt by giving him more credit. And you still can’t trust a politician…or his money.

The election "changed everything," shouts the headline on today’s International Herald Tribune. But the eternal verities still apply; Barack Obama is not going to change them.

And that means that a slump caused by too much debt cannot be made to disappear. You can disguise it. You can delay it. You can push the losses onto someone else. But you can’t escape it.

And now, thanks to an economist with the Nomura Research Institute in Tokyo, we think we have a clearer idea of how this downturn is likely to turn out.

We’ll get to that in a minute. First, a quick look at what is going on the world of money.

The Dow rose 305 points on Election Day. Investors are looking for any bit of flotsam or jetsam they can find to buoy them up. Anticipating an Obama victory, they thought things might change. The price of gold shot up $39. Gold buyers have their suspicions too.

"Post election rallies" are more myth than reality. Stocks rose strongly following Reagan’s first election to the White House…and again when Bill Clinton was elected. But neither Bush, pere nor fils, boosted stock prices.

Still, an Obama rally is probably on its way. Investors are ready for it. Practically every major investment guru is calling for it. "Stocks are cheap," they say. "This may be the greatest investment opportunity of our lifetimes," they add. Even the ‘contrarians’ are getting aboard. "Investors are frightened," they point out. "Confidence is down," they explain. "There’s blood in the street," they clinch the argument.

All over the world, people look to Washington with hope in their hearts…and humbug in their heads.

"A New World Dawns" proclaims Britain’s Daily Mirror.

People look at Obama and think they see a young Kennedy…they think they’ll be about to rerun the tape and do a little editing – a New Frontier without the Vietnam War…a Camelot without Lee Harvey Oswald.

But it’s not a New Frontier that America faces…it’s an old, worn out flimflam. It’s not a new dawn at all – a dark night is falling.

Our old friend Adrian Day, originally from London, England, now from Annapolis, Maryland, explains:

"The position of the United States today is approaching that of Britain at the end of World War II. Britain had been the world’s dominant economic, political and military power, with the world’s reserve currency. But by 1946 it was militarily stretched beyond its capacity, and highly indebted. The U.S. took over the #1 spot and the dollar became the world’s reserve currency, with the pound falling from five-to-one in 1946, down to parity four decades later.

"The problem with being the world’s reserve currency is that more money is created than is necessary for the domestic economy’s needs. For decades, the United States has created far more dollars than it needs, but it didn’t matter so long as other countries were prepared to buy and hold those dollars. But those dollars still exist. As other countries lose confidence and diversity, those dollars eventually come back…"

Yes, dear reader…a man must always compensate for his strengths. The U.S. had the world’s strongest and most reliable currency for half a century. It was our greatest strength and our biggest export. But this much IS changing: the dollar is no longer our biggest strength; it is becoming our biggest weakness.

*** Yes, we are figuring it out, dear reader. And the clearer the picture becomes, the more we realize we were right all along – almost.

"You really got the Japan story right," said Theo Casey, a London-based colleague yesterday.

Theo had just read our book, Financial Reckoning Day, written in 2002. In it, we suggested that America was following in Japan’s footsteps. At the time, we wrote so much about it in The Daily Reckoning that readers begged us to change the subject. And then…the subject changed on its own. Instead of beginning a Japan-style correction, the U.S. economy took off in an American-style bubble.

But now the bubble has popped. What now? Want to know? Just look at Japan!

Richard C. Koo has prepared a remarkable report: "The Age of Balance Sheet Recessions – What Post-2008 US, Europe and Japan Can Learn from Japan 1990-2005."

His argument is not far from the one we made six years ago. In the 1980s, Japan ran up stock and property prices in a spree of debt and leverage. Then, when the bubble popped, the usual monetary stimulus didn’t work. The Bank of Japan cut rates to almost zero…still, few people were willing to borrow.

The economy did not recover; instead, it got worse and worse until 2005 – 15 years later – when stocks had lost 72% of their value, land was down 81%, and golf course memberships had sunk 95% from their peak.

The problem, he explains, was that it was a "balance sheet recession," not a typical business cycle downturn. Companies, banks, and individuals had to pay down the debt that they had accumulated in the boom; they did not want to borrow more money, even at zero interest rates. For 7 years, from 1998 to 2005, net business borrowing went negative – meaning, businesses were paying off more debt than they were taking on.

This came as a shock to modern economists. Japanese officials were flummoxed. U.S. economists accused them of not acting swiftly enough…or not having the stomach to let the big banks fail. But almost no one seemed to understand what was really going on. They should have. Irving Fisher described it back in 1933, observing that when people who are deeply in debt get into trouble they usually sell assets. He called it a "stampede to liquidity." Investors dump stocks and property for any price they can get – desperate to pay off their debts before they are dragged into bankruptcy.

This is the phenomenon known to economists as the "fallacy of composition." What is good for every individual investor – cutting expenses, paying off debt – turns out to be bad for the economy itself. Asset prices fall. Sales fall. Unemployment rises. The slump deepens.

In Japan’s case, combined capital losses from land and stocks grew from 1990 until 2002, at which time they reached $15 trillion – or 3 years worth of Japan’s GDP.

You can do the math yourself, dear reader. America’s GDP is about $14 trillion. Multiply that times three and you get $42 trillion. So far, the U.S. has lost about $4 or $5 trillion in housing prices…and maybe another $6 trillion in stocks, for a total of about $11 trillion, maximum. A long way to go…

Tomorrow, we’ll explain why the U.S. will follow Japan’s lead – but only to a point. In short, Japan didn’t have the world’s reserve currency. And Japan also had savings – mountains of savings. The initial conditions are very different in the United States; the outcome will be different too. More tomorrow…

*** "The Joy of Thrift" is the cover story on this weekend’s Sunday Times Style supplement. As predicted, suddenly, thrift has become stylish.

"It dawned on me that nothing was going to change unless I made fundamental changes in my life," writes India Knight, describing her close encounter with bankruptcy. And then…the damascene conversion:

"Five years ago, buying stuff I didn’t need was my idea of bliss. But these days my treat of choice comes from a yarn shop in north London…and if I want to give someone I really care about a present, I may actually – gasp! – make them something. And here’s the clincher: I would consider the something as chic and stylish as anything a department store could have produced. Chicer, sometimes…

"There is something really gross about wanting something and buying it, just like that…thank you, AMEX."

*** Thrift has not exactly become chic in the Bonner household, but it is perhaps less out-of-style than it was a few months ago.

We are all skyping, rather than using the telephone. Our gardener has been given notice: no more overtime. No more fancy restaurants either; the Italian dive across the street will do just fine. And hold the $50 bottles of wine; we can’t tell the difference anyway.

So you see, we are roughing it. In this time of national hardship, everyone has to make sacrifices.

Your editor has dramatically reduced his commuting expense. Rather than buy a subway ticket for 1.6 euros, he rides a bicycle. These two-wheeled, unmotorized, non-electronic vehicles are big moneysavers.

To begin with, we don’t have to buy gasoline. And a bicycle costs you almost nothing to maintain – just adjust the brakes yourself; it’s easy. And you don’t need expensive auto-insurance.

Best of all, there are no costly repairs to make after a fender-bender – especially if you’ve fixed the brakes yourself. You’ll have no lawyers to pay. No points on your license. Almost all encounters between delivery vans and bicycles are fatal to the fellow on the bicycle. What a savings!

Until tomorrow,

Bill Bonner
The Daily Reckoning

Playing the Tax Credit Card originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

In the last few weeks, it has become clear that the current financial meltdown is not our usual, run-of-the-mill crisis. It’s supersized, inexorably linked to the rest of the world, ruled by chaos, and precariously perched atop a mountain of debt. "What makes this crisis different from some of the earlier ones," says IMF Historian James Boughton, "is that the interlinkages among financial institutions are much greater now than they used to be."

Daily efforts to "thaw credit markets," "provide liquidity," and "support financial stability" only add to the myriad market dislocations. And despite what we may hear from politicians and the news media, recovery is unlikely to be "just around the corner."

The party really is over. We are facing hard times, no matter what the government does. If it continues to prop up the sick markets, it will only delay and worsen the inevitable deep recession.

To survive the current financial crisis and the accompanying economic downturn, we must understand the big picture, and how it will be affected by the slew of "support" from the federal government.

Casey Research accurately predicted the specifics of the crisis in its International Speculator edition of March 2007:

For one thing, at the point that falling prices leave homeowners with mortgages exceeding the value of their homes, default rates will soar. This, in turn, will put lenders that hold large amounts of mortgage debt at risk, and possibly jeopardize the solvency of Fannie Mae and Freddie Mac, since they guarantee much of this debt. If these mortgage giants faced collapse – and they are already in well-documented trouble – a government bailout involving hundreds of billions of dollars would be a likely next step.

The impending calamity – mass housing foreclosures, failing banks, Fannie Mae and Freddie Mac in ashes, millions of personal bankruptcies – is so dire… most people can’t even conceive of it. And indeed it may not hit us this year, or next, but the market always corrects itself, and this time will be no exception, sooner or later.

We have said before, and we repeat again: Rig for stormy weather.

Now the Casey Research team forecasts something outside the realm of any recent experience: the Greater Depression may be looming on the horizon.

Doug Casey coined the term "Greater Depression" in his best-selling book Crisis Investing, published in 1979. Today it resounds throughout the land; even CNN’s Glenn Beck recently used it in an op-ed piece. And the signs are increasing that a depression may indeed be what we are moving towards.

On September 30, 2008 (end fiscal 2008), the Congressional Budget Office reported a record federal budget deficit for the year of $455 billion, up $293 billion (or 181%) from fiscal 2007.

And that does not yet include the Fed’s bailout package for failing banks, Fannie Mae and Freddie Mac, and various other "economic stimuli." The chart below shows that the $700 billion agreed to by Congress may have been a very optimistic estimate.

On October 3, President Bush signed into law the Emergency Economic Stabilization Act of 2008. With this Act, Congress and the president have ensured a runaway government deficit next year…one sure to exceed $1 trillion. Along with total federal debt outstanding already around $10.3 trillion, unfunded liabilities of at least $50 trillion, and many new programs and tax rebates promised by both presidential candidates, this does not bode well for the global economic outlook.

As if that was not enough, during the past few weeks, the Fed increased the country’s monetary base by as much as 20% to shore up the financial systems.

Federal budget deficits facilitate "loose" (expansionist) monetary policies, and these policies set in motion the business cycle. As the economy enters the cycle’s "bust" phase, massive federal deficits have left the government with only one option – to try to inflate itself out of the current crisis, regardless of the impact on the value of the dollar.

A rapidly growing money supply at the same time the biggest credit bubble in 25 years bursts makes for a less than desirable scenario – one that could make the stagflation of the ’70s look like a walk in the park. In March 1975, industrial production fell by nearly 13% while the yearly rate of CPI growth jumped to around 12%. It took another seven years and a second recession before the U.S. was able to break from the stagflation cycle.

What we are likely in for now is an unprecedented period of price inflation, economic depression, and high unemployment, i.e., not just stagflation but depflation (inflationary depression).

Depflation will affect the entire population, and its effects on people’s personal finances will manifest in multiple ways.

? Purchasing power declines as prices for consumer goods increase faster than wages.
? Taxes levied on businesses and individuals increase when nominal incomes rise.
? Late recipients of new money incur cost of additional hidden tax.
? Cost of money (interest rates) increases, hurts investments in capital goods, stocks and bonds.
? Once expectation sets in, it becomes a self-feeding phenomenon, taking years and a severe recession to work itself out.

Just like a shot of adrenalin administered to a sick patient generates an apparent revival, only to have the patient collapse as soon as the injection wears off, the artificial monetary injections by the Fed will do the same. Paraphrasing former Fed chairman Paul Volcker, "Once you have a little [monetary] inflation, you need a little more". As with any medicine, its effects wear off and become less potent the more "injections" are received.

At this stage, your primary goal should be asset protection. Once that is in place, you will be in a better position to hunt for the opportunistic profits one can only find in times of crisis.

Regards,

Olivier Garrett
for The Daily Reckoning
October 21, 2008

P.S. We at Casey Research have long foreseen what is unfolding right now…and those investors who followed our recommendations have successfully preserved their wealth.

We believe in making the trend your friend…otherwise it can be a fearsome enemy.

Which is what The Casey Report is all about – giving you the pertinent and well-researched information on big economic trends unfolding at this moment, and how best to invest to make them work for you, instead of against you.

Yesterday, prices went up on Wall Street… The Dow rose 413 points. There was no follow-up this morning, as investors eyed a mixed bag of 3rd quarter corporate earnings.

But, investors are in a pretty good mood, all things considered. After all, Warren Buffett is bullish on stock prices… Warren is putting his money and his mouth in the same place – equities. He says he’s sure they will do better over the next 10 years than cash.

Here at The Daily Reckoning, we are not rich enough to argue with the Sage of the Plains. Besides, we think he’s right. Or, almost right.

Stocks will probably do better than cash over the next 10 years; but mostly because cash will probably do very badly. Our guess is that everything will do better than cash. Except bonds – which represent cash deferred into the future.

And here, for the benefit of new readers and long-time DR sufferers alike, we give our view:

When Mr. Market goes into a sulk, he takes a long time to come out of it. Real bear markets last 10…15…20 years. And judging by the meltdown in the financial sector…and the rapid losses we’ve seen over the last three weeks…we have a real bear market on our hands.

This bear market actually began in January 2000 when the tech sector crashed. But it was reversed when the feds opened a Hoover dam of liquidity, beginning in 2001-2002. Stocks floated higher…and consumers, business and Wall Street actually increased their indebtedness.

Every bubble expands until it finds its pin. The bubbles in housing, debt and the financial industry began deflating in 2006/2007. But the big popping noise was only heard in September/October of this year, when Wall Street itself imploded.

And now, the feds are out of easy options. They can’t push more credit on the poor consumer; because the credit pipes burst along with the bubble in the financial sector. Besides, if they were to lend the consumer more money, what would they lend against? House prices are falling.

With no more easy credit available to them, consumers are doing what they have to do – they’re cutting back. How much? For how long?

No one knows the answers to those questions but our guess is this: more and longer than you thought.

Why so?

"The real deterioration in the economy is only just beginning," said a London banker.

Every businessman we know is sharpening his pencil. He’s looking at his list of expenses and circling items that he thinks can be cut. Most of those items have someone’s name connected to them. Unemployment is going to rise more than expected. As it does, consumer spending is going to fall more than expected.

As to what to do about the weakening economy, says the New York Times, a consensus is forming. As might be expected, the mob wants more bread. And as might be expected, the feds are eager to give it to them.

Today’s headlines tell us that another stimulus package is being prepared in Congress. The pols are getting out the lights, the shiny balls, and the garlands – they’re going to Christmas tree this one even better than the last. Earmarks, nosemarks, cheekmarks – this new bill will have the marks of every greedy S.O.B. in Washington on it. Your town need a bridge? Better get the request in soon, so your Congressman can hang it on the tree. How about a new ‘community center?’ Got any indigenous people around…any victim group…any bunch of layabouts or n’er do wells who need handout? Cripples? Half-wits? Republicans? Kiwanis? Butchers? Car dealers! Yes, give the poor car dealers a break. They’re not even selling Japanese cars, according to the news.

Yes, dear reader, the fix is in. Ben Bernanke said he backs another stimulus bill. And this new measure should stimulate just about everyone; it’s sure to include more ‘rebate’ checks…infrastructure spending…and giveaways to anyone with a decent lobbyist.

But where does the government get more bread? More below…

*** And the financial crisis is not just contained to the United States.

"China is slowing down," explains Chris Mayer, "There are a lot of ways to tell this, but one of the best ways is to look at the China operations of international companies. For example, Best Buy reports its China same-store sales fell 7%. Kingfisher, which is a do-it-yourself chain, reported sales fell 19%. Yum! Brands, which runs KFC restaurants in China, said sales were up 5% – which is not so bad, but they were up 11% in the same period in 2007.

"So as China slows, that will have a big impact on commodity markets. And it may also be a bellwether for the rest of the emerging markets. Anyway, it’s another development we’ll watch closely when our businesses report. We have several companies whose international operations were a big part of the appeal and were growing much faster than the rest of the company.

"I still believe overseas markets will grow faster than the more mature Western markets and that we’ll be glad we have exposure to these markets over the long haul. As I say, we’ll have a better idea of a lot of these things soon."

*** Where do the feds get more bread? Their granaries are empty. And they’re already borrowing at the highest level in history.

"Where is the Treasury getting $700 billion?" asks Jane Bryant Quinn.

"It will borrow worldwide, by selling Treasury securities. Right now, there’s a strong demand for them, so it’s selling into a welcoming market.

"It is remarkable how much capital the U.S. has been able to attract to finance its borrowing needs," says Brian Sack, Washington-based senior economist at Macroeconomic Advisers. That might change, he says, "but there are no clear signs yet.”

When the clear signs appear, it will probably be too late. That’s just the way things work. Crises build…and build…like pressure in a volcano. Unless you’re paying close attention, the whole mountain explodes before you know what is happening. Then, it’s amazing how fast things happen. And it’s astonishing how often you say to yourself…’I knew that was going to happen" and wonder why you didn’t do the obvious thing to protect yourself.

As political columnist David Yespsen said in I.O.U.S.A., "I think it’s going to take a crisis before America responds to [the financial crisis]. This is America, we don’t do anything until something reaches a crisis; whether it’s military re-armament before World War Two or whether it’s this question now. We’re not going to be willing to take this pain until it gets to be a real problem."

And it has become a real problem. Eventually, the feds will find it harder to raise money. Lenders will not be so kind. Investors will be not so dumb. And the full faith and credit of the United States of America will not be such a sure thing.

A dear reader poses a good question:

"Can you give your readers an idea what portion of a $3 trillion annual budget must be earmarked (bad word?) to service the debt annually on a $9 trillion national debt? Also, if every thing remained static, how long it would take to pay down the debt?"

As to the first question, the writer is behind the times. The official national debt is now over $10 trillion. And for ease of calculation, let’s say it bears an interest coupon of 4%. That would put the annual interest charge at $400 billion…or 13% of a $3 trillion budget.

But remember, the U.S. government does not take in enough in tax receipts to pay current costs. With a falling tax take and rising social costs – not to mention rising bailout bills – the deficit is expected to come in above $1 trillion. Or, to look at it differently, the entire interest payment has to be borrowed too – in fact, more than 2 times the interest charge.

So, in 2010, the interest charge would be another $1 trillion x 4%, or $40 billion more. Imagine that the deficits go to $2 trillion…or beyond. Or that a $1 trillion deficit persists for a few years. It wouldn’t be too hard to imagine a national debt greater than the GDP in just a couple of years.

But it’s not just the deficit that matters…it’s also how much the feds have to pay to borrow the money…and how much new money, "out of thin air," they create. We will pass over the monetary theory and go right to the point. We recently saw a chart of "money aggregates." The chart roughly measures the supply of "money." After being nearly flat for the last few years, it has suddenly begun to shoot up. The feds are not just innocently borrowing, in other words; they’re inflating too. As expected.

*** If we’re right about inflation, you might want to buy some gold at today’s low prices.

Of course, we asked our old friend Issy Bacher, from South Africa, what he thought of the pullback in gold prices. In short, he thinks gold could pull back even more:

"Cycle analysis of the gold price doesn’t look encouraging at present. I gave an interview on CNBC some time back when I gave a forecast of $ 750. Gold was around $ 950 at the time.

"It got to $ 750 on 12/9/2007 Cycles again suggest that it could test support round the 750 dollar level. As the cycles are dynamic, we re-examine the cycles if it gets to that level. The strong support for gold is around $650."

We don’t know where the price of gold is going. But we know what we’ll be doing if it goes to $650; we will be buying more.

Until tomorrow,

Bill Bonner
The Daily Reckoning

U.S. in Crisis Mode – What’s Next? originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.