There were multiple successive and deeper recessions. Gold was rising as the dollar was seen as a joke. Howard Ruff (a good friend to both of us when we were starting out!) and almost every newsletter writer were telling people to buy gold and freeze-dried food to protect themselves against a near certain economic, if not apocalyptic, catastrophe. Unemployment was high and rising for a decade.

The correct answer to the question, “Where will the jobs come from?” back then was “I don’t know, but they will.” And it is the correct answer today.

In 20 years, no one will want to come back to the halcyon days of 2005. Our kids (all 13 of them) are getting ready to live through what will be the most exciting period in human history. There will be a century’s worth of change, measured by the standard of the 20th century, just in the next ten years, and then we will double that pace in the next ten after that. Medical miracles that will mean our kids and grandkids will live a lot longer than their dads, although I intend to be writing well into my 80s, like our mutual hero Richard Russell.

There will be whole new industries developed in the US. How do I know that? Follow the money. The rest of the world spends a fraction on research and development that we do. Where do you go if you are looking for venture capital?

Do I care if the Chinese and the “developing” worlds are far better off, relatively speaking, than the US in 20 years? Not a whit. Good on them. I hope they make discoveries and inventions and new businesses that benefit us all. But we are not going into some long dark night. We, and our kids, get to choose how we respond to what is the reality of the day.

Our nation had to almost hit the wall in 1980 before a Volker could come along and force us to take the pain of recessions to beat back inflation. And we will have to come perilously close to the wall this time before we take action as a nation. Way to close for comfort. Maybe you are right, and we have a soft depression. I hope not, but even so, the world will be better, far better, in 20 years, with far more opportunities than today.

It was not fun starting new businesses in the ’70s and early ’80s. But we did. I remember coming to Baltimore and being (literally) afraid to get out of the car to visit your offices in the slums. But that was what you could afford. A far cry from the chateau in Ouzilly.

I lived in a small mobile home. Tiffani was born there, and we converted part of the kitchen to be her bedroom. (Yes, I was white “trailer trash.”) But I got up every morning just like you did and killed as many alligators as I could. The rest had to wait till the next day.

And that is the legacy our kids have. They know what it is to wade into the swamp every morning. Never quitting. In thinking about this, you may be the father I respect the most. You have raised your kids to be multi-lingual children of the world. What a work ethic. How did you get them to scrape window shutters at your chateaus? (I actually saw this, and my kids marveled.

Thereafter I threatened to make them go live with you when they did not act right!)

You have given your kids the opportunity to follow their dreams, even demanded that they do so. And such dreams they (and mine) have. Will they succeed? Who knows? But they will go at it with gusto, in a world with more opportunities than you and I ever imagined 40 years ago. And, oh boy, were we optimists back then. How else could we have done what we did? If we believed the rhetoric that the world was coming to an end, would we have dared to venture out?

You cannot have raised your kids to be such bold adventurers without instilling in them a certain high level of optimism. I am going to out you, Mr. Bonner. You present yourself to your readers as a bona fide end of the world pessimist. But you are a really and truly a closet optimist. Your whole business empire (and what an empire it has become!) is based on finding people who are optimists, in the sense that they think they can actually get people to send them money for what they write. Which they do! Even if it is to read why the world will come to an end, which it thankfully never does.

You are right in this: it is personal gumption that makes or breaks us. There are those who started out with less than we did (hard to imagine but true) and made a lot more. And there are those who started out with far more and made less. But there are very few who are happier than either of us. Or luckier.

Our kids? It is not the times which dictate the man (or daughter!), but the response of the man which dictates his own time. Today has a brighter future for someone young than any other time in history, whether they are in the US or Brazil or China. They just have to seize it.

And as our kids do just that, and as the millions of kids of those who read us do so, and the billions of kids who are just now getting ready to bust loose all work to achieve their dreams, the world is going to be a far more fantastic place. Smooth ride? Not a chance. We didn’t get one, and in thinking through history, there have not been many smooth rides. Why should we think we will get any better? Our kids will just have to live with our generational (and individual) iniquities, government debt and all, and figure out how to master their own fates. But if I had a choice to take the ’70s or today? In less than a heart’s beat I choose today. And I bet you would too!

Regards,

John Mauldin
for The Daily Reckoning

It’s More Than Half Full 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.

A CONGRESSIONAL TANTRUM
by John Mauldin

Long-time readers know that I do not think the world is going to devolve into a soft depression because of the imbalances in our trade deficit and our large and growing debt. Those will have to be dealt with, of course, but I think it will happen in the normal context of the business cycle. A recession here, a falling dollar there, and slower than trend average U.S. growth over the next five years or so and we get to where the re-set button has been hit. It will not be fun, but it will not be the end of the world. It is what I call the Muddle Through Economy. I am actually quite optimistic about the investment opportunities once we get through that period, with the usual caveats and asterisks.

Dubai Port Deal: Smoot and Hawley

But I have maintained for many years that the one thing that could change my basic optimism is a new wave of protectionism. Senator Smoot and Representative Hawley infamously sponsored a bill in 1930 that raised tariffs on a variety of products in order to “protect” American jobs. Of course, the rest of the world retaliated and soon we went from a recession into a global Depression. Unemployment soared and all those jobs we “saved” went away.

Recessions are part of the business cycle. The Fed cannot stop one, try though it might, nor can Congress write legislation outlawing recessions. And in the main, and with a few exceptions, they have not on balance been all that bad. One can make the argument that they are needed to correct imbalances and “irrational exuberances” here and there. Typically, unemployment rises a few percent but comes back in a few years, the stock market falls but comes back and profits fall but go on to make new highs after the “reset” button is hit.

I am not trying to be cavalier. If it is your job or investment or profits that get hit, it can mean some very long and sleepless nights. Been there. Done that. But for the vast majority of U.S. citizens, the last recession had little effect. Unemployment never rose above 7%, and corporate profits came back quite strong. The next recession may be worse, but it will end soon enough. That is the way of the business cycle.

But while recessions are part and parcel of the economic cycle, it takes a government to really mess things up and create a depression. Show me a depression (not a shorter term recession!) in a free society that was not the result of government incompetence or some form of direct government involvement. You can’t. Usually they are the result of multiple and coordinated government groups all working together to make things better and having the opposite effect.

Yes, I suppose you could say that Smoot and Hawley were just responding to the zeitgeist of the times, that the voters were demanding their jobs be protected, so that the American people got what they deserved, but Congress and the Fed aided and abetted. President Hoover should have used a veto. For that alone, he deserved to be defeated two years later.

Last week, an updated version of Smoot and Hawley’s Congress put together a veto-proof gaggle to stop the United Arab Emirates from buying a British port management company that ran six of our nation’s ports. Security was the ostensible reason, but anyone who did their homework knows that national security on any level was never at risk. This congressional tantrum bothers me on several levels.

Dubai Port Deal: Port Security

Our ports are run by a number of companies that are not U.S. based companies. Five ports have Danish firms running them, for instance. Two are run by the Chinese. Basically these companies move freight. Pick it up here and put it there. They have nothing to do with port security. Port security is the province of U.S. Customs and the Coast Guard. And they hire American union workers.

The U.A.E may be the largest non-U.S. port service for the U.S. Navy in the world, based in Dubai. They are a solid ally and a voice of moderation and stability in an area of the world where such is needed.

There is a process where foreign investments in the United States that have security implications are brought before the Committee on Foreign Investment in the United States (CFIUS). This governmental inter-agency group looks at foreign investments, and if one of them sees a red flag, they run it further up the command chain. This was an investment that, after being thoroughly investigated, caused no concern and was approved. And then some politicians saw an opportunity for political gain.

Now, someone in the administration at the middle levels should have seen the political implications of this deal. Sadly, the Bush administration does not do a good job of explaining their policies. This should have privately been run up to Congress and vetted there before the approval went through. So, a lot of the blame should be laid onto the administration for having a “tin ear.”

The next thing we know, talk radio is going over the edge, calls into Republican congressmen are running 9-1 against the deal in an election year that looks tough for them to begin with, Democratic Congressmen see a chance to appear concerned about national security and really tweak the President and before you know it, there is a move to stop the deal.

There is a reason for the CFIUS process. It works, and it keeps politics more or less out of business deals. But now, Congress has learned it can basically look at any deal and say that it’s against the national interest for some foreign company to buy a U.S. company. And every tin pot congressman who wants to posture in front of a camera and who has a company in his district that becomes a target will now want to get involved. Companies that lose a bidding war or that have an axe to grind will complain to Congress: “I don’t want that foreign company competing on my turf and taking U.S. jobs from my employees!” Shades of Smoot-Hawley!

We have spent decades persuading nations around the world to open up their countries to investment. And they have. We have over $10 trillion invested outside of the United States, which made American firms $500 billion last year, a little under 5% of our GDP! That is about $1,600 for every man, woman and child in the United States. That money gets paid out as dividends, gets invested in our economy, and goes to pay our workers.

Dubai Port Deal: Foreign Investment

Last year, foreigners increased their investments in the United States by $1.4 trillion, in a wide variety of investments. Without those dollars, the U.S. currency would have collapsed, interest rates would be through the roof and we would be facing (or in!) a REAL recession, not the garden variety ones we have had since 1990.

“A study by the Organization for International Investments finds that about 5.3 million Americans are directly employed by foreign owned firms with wages averaging $63,000, or about 50% more than the average U.S. wage. Foreigners are not buying up America’s wealth; they are investing in ways that add to it,” reports the Wall Street Journal.

That means that about 8% of American workers are employed by foreign-owned companies. You can bet they are happy they have the higher paying jobs. If not, they would simply leave. But the line for those high paying jobs is long.

But now, there are those in Congress who would like to stop that wealth and job creating foreign investment.

“In recent weeks Members of Congress have suggested that the foreign-ownership ban should apply to roads, telecommunications, airlines, broadcasting, shipping, technology firms, water facilities, buildings, real estate and even U.S. Treasury securities.” (The Wall Street Journal editorial, March 10, 2006)

How does this sound to those nations that we are trying to get to open up to U.S. investments? Why should they cooperate id we re not going to practice what we preach, when it is in our clear interest to do so?

If this was just the U.A.E. deal, I could rest easier. But last year it was the dust-up over China buying a mid-size U.S. oil company that had relatively little U.S. production. We have Senators Charles (Smoot) Schumer and Lindsey (Hawley) Graham cooperating in a bit of bi-partisan idiocy to try and put a 27% tariff on Chinese goods.

And let’s be blunt. To suggest such a thing demonstrates either astounding economic ignorance or simple political pandering of the worst kind. Probably both. Do we really want to raise the price of everything from China by 27%? On items that we no longer make here? Do we want to risk the start another trade war? Or have the Chinese stop buying U.S. Treasuries? Can you say recession, boys and girls?

Regards,

John Mauldin
for The Daily Reckoning
March 15, 2006

Editor’s Note: John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. As well as being a frequent contributor to Capital & Crisis and Strategic Investment, Mr. Mauldin is a New York Times best-selling author with a unique ability to present complex financial topics and make them understandable to the lay reader with insights into the current economy and hedge fund industry. His latest book, Just One Thing, was released in December of 2005.

You can purchase your copy here:

Just One Thing

“What can be avoided / whose end is purposed by the mighty gods?” asked Julius Caesar, before he was stabbed dead on the Ides of March.

Despite the omens, no history was made yesterday – at least, not in U.S. financial markets. At the close of the day, prices were not far from where they were when the first rays of sun struck Manhattan.

But, if we are right about the way the world works, history kept bumping and grinding anyway, perhaps in secret…grinding all human conceits exceedingly fine and exceedingly sure. Who knows what ends are purposed by the mighty gods? But, who doubts that they can be avoided?

In today’s Daily Reckoning, dear reader, we offer what you might call a General Theory of Grinding. We begin by insisting that every man needs a theory as much as he needs a pair of pants – perhaps more. Without it, he is ridiculous or at least semi-functional. All we humans have to judge the world around us are our eyes and ears, but what do these senses pick up? They pick up a rush of color, light, sound – raw data.

Without a theory, this “data” is meaningless. It is just “noise.” We need theories to interpret it and give it meaning. Theses theories transform the rising edges of a woman’s mouth into a smile and a growing complex of bright red light into a double-decker bus headed for Waterloo Station. How would we know what would happen if we stepped in front of it? We have never done it before. We’ve never seen anyone do it. Yet, we have a theory that tells us that if we position ourselves in front of a moving bus, we will be crushed by it.

More on the General Theory of Grinding below…

Among other things, the gods are currently grinding down the boom in real estate, support for the Iraq war, consumer incomes and spending power, the U.S. balance sheet…and the empire itself.

The Mortgage Bankers Association expects mortgage originations to drop off by 20% this year; it says refinancing should fall by 40%. Without easy finance, consumers have less to spend. Yesterday brought news that retail sales had fallen in February, for the first time in six months.

Why?

“Too many consumers have been attracted to products by the seductive prospect of low minimum payments that delay the day of reckoning, but often make ultimate repayment of growing principal far more difficult.”

Speaking was U.S. Comptroller of the Currency John C. Dugan, and what he was speaking of, specifically, was the way in which consumers took out interest-only or negative amortization mortgages.

“In the last two years, however,” Dugan continued, “we have seen a spike in the volume of payment-option ARMs which are no longer confined to well-heeled borrowers who can clearly afford them. Increasingly, they are being marketed as ‘affordability products’ to borrowers who appear to be counting on the fixed period of exceptionally low minimum payments – typically lasting the first five years of the loan – as the primary way to afford the large mortgages necessary to buy homes in many housing markets across the country.”

We already know what will happen. We see the signs before us. Foreclosures are rising. Households which bought more house than they could really afford are going broke. Consumer spending has become a little wobbly.

The expected effects on the housing market itself are starting to show up. Sales are down. Inventories are rising.

In California, the housing boom has raised prices to the point where the median wage earner in L.A. County can only afford one out of every 35 properties on the market. We wonder who, then, will buy the other 34? Other people are beginning to wonder, too. Transactions in January fell 24% from the year before.

Speaking of prices, “I would expect a general decline of 5% to 10% throughout the country, some areas 20%…and in areas where you have had heavy speculation, you could have 30%,” says Angelo R. Mozilo – a man who ought to know. Mr. Mozilo is the CEO of the nation’s largest mortgage lender, Countrywide. While we have no reason to doubt Mozilo’s words on the subject, it is his actions we’d bet on. According to Grant’s Interest Rate Observer, Mozillo “has been a steady and heavy seller of Countrywide common for two years.”

We recall an estimate reported in these epistles a few months ago. Fully 40% of the job growth since 2001 is said to be the fruit of the housing boom. If that is so – and if despite these new jobs, real wages have gone down during this period – we can’t help but wonder what will happen to wages when the boom ends. It seems likely that they will go down further. And, it seems likely that consumer spending will fall, too. Is that when history starts up again?

Yes…or maybe even sooner.

[Ed. Note: The authorities are getting nervous. They’re afraid of what could happen as these marginal buyers have to pay up. Regulators are stiffening lending rules and pressuring mortgage companies to be more careful with their money…and yet, the amount of defaults will still rock these lenders…and everyone in the United States will feel the aftershock.

More news from the pundits at The Rude Awakening…

————–

Eric Fry, reporting from Wall Street:

“The quest for alternative energy sources has gained increasing urgency. This quest is no longer the exclusive domain of science geeks. $60 crude oil has contributed a tangible profit motive to the search for viable alternatives.”

————–

Bill Bonner, back in London with more views on various things…

*** Support for the war in Iraq is deteriorating. A new poll shows two-thirds of Americans already think the war was a “mistake.” History is grinding away, slowly but surely, at our war president.

When the war was first announced, Americans were fully behind it, and suspicious of anyone who wasn’t. We lost a good number of dear readers because they couldn’t put up with our standoffish attitude to the war. One wrote to say he wished U.S. bombers would drop a load on our Paris office on their way to Baghdad!

But, we were never really “against” the war. That suggests a degree of earnest do-goodism of which we are incapable. We take the world as we find it; we let the gods do their work. We only try to understand what they are up to, not stop them. Maggie Thatcher said an attack against Iraq was too “uncertain.” She argued against British involvement. The cynical French remembered Algeria; they wanted nothing to do with it.

While we shared many of their views, we saw the war as a historical necessity. Every empire needs to find a way to look ridiculous; it has to lose its pants, in other words, when the theory holding it up finally disintegrates. Nature loathes a monopoly. A successful empire has a monopoly on the use of organized force. Nature conspires against it, tries to undermine it and eventually ruins it. Every great empire also needs to take Baghdad at one time or another. The English took it. The Mongols took it. The Romans took it several times. Why shouldn’t we?

Wouldn’t that be a good way to weaken the empire, too? It would cost a fortune, stir up enemies, and tie up the imperial army in a futile campaign against nobody of importance. If you wanted to destroy the U.S. Empire, it would seem to be the perfect project. All nature needed to accomplish her dirty plans was an American administration foolish enough to undertake it. In Bush, Cheney and Rumsfeld, she found her stooges.

*** Back to the General Theory of Grinding…

Against the theory that modern American democratic capitalism always makes things better, we offer our own theory: Things don’t get better at all. Technology improves. Material living standards get better. But, down in that old “rag and bone shop of the heart” – where central bankers toil, politicians despoil, lovers and history grind away – things remain same.

We hold this truth to be self-evident: Everything degenerates, everything breaks down and everything is born again to new life.

“Wait a minute,” you say, “things are getting better.”

We expect you might toss the Great Crusades in our face, the Hundred Years’ War, or the Aztec butcheries.

“See, we don’t do things like that any more,” you say. But, we offer this rebuttal: Auschwitz, the 20th Century, the War on Terror!

Last night, we read an account of the Soviets’ advance on Berlin in World War II. Was it much different from the Mongol invasion of the 13th century?

If there has been any progress in human affairs, dear reader, it has been very slow, very slight and very fragile.

What we see when we look around is a constant upwelling of institutions and ideas, and then, a constant wearing away, erosion, and degradation of them. That is history grinding away – churning, burning, turning everything up and down, over and around. Stock prices rise – only to fall again. Empires flourish – only to degenerate and make way for a new empire. Currencies, companies, economies…all have their moments of glory – and their moments of sorrow.

Even modern democratic capitalism gets ground down by history, as we will see tomorrow, when we take up the General Theory of Grinding further.

*** Flash Tip: here’s how to make some money. Sell short the Gulf! The Egyptian stock market has gone ga-ga – up over 1,000%. Stocks throughout the Gulf area are selling at 44 times earnings. Dubai is in a property bubble; they’re putting up the Burj Tower, intended to be the tallest building in the world.

Sell! If it doesn’t work out, please forget we suggested it.

*** And here is one of our colleagues, Justice Litle, with another way to make some money:

“Three words: ‘Buy the tropics.’

“It’s sort of a conundrum why the tropics have fared so poorly, in economic terms, over the past hundred years. There is a band around the equator that practically guarantees squalor if your country falls within it.

“The Economist recently talked about a theory for why this is so. Basically, the colder northern regions had to innovate in order to deal with harsh living conditions, and thus ‘necessity as mother of invention’ led to the implementation of industrial society and all that came with it. In the tropics, life was good mon – as the Jamaica commercials say – and no one had to do much to get ahead. And so, they didn’t; the tropics became mired in relative poverty.

“But all that industrial revolution in the northern climes has hit an apex – the next phase being a tearing apart of the social fabric as knowledge economies stride forth from the ashes.

“So now, in the 21st century, the mega-trend industrial-political shoe is on the other foot: ugly for the northern climes, perfect for the tropics.

“Over the next 50 years, that whole band-around-the-equator area, long neglected except as a vacation spot, is going to become a hotbed of knowledge migration, capital migration, technology implementation, passport arbitrage, tax treaties…you name it. Technology enables all this, as does the fall of the welfare state via capital and physical flight…and the relatively pristine state of the tropic – their lack of industrialization – is suddenly a major advantage.”

*** Yesterday’s excursion to Paris did not go as planned. Your editor stepped into the apartment his wife had chosen and his face gave him away immediately. It was dark. We looked out the window and saw only our own face reflected in the glass of a similar apartment building right across the narrow street.

“You don’t like it,” said Elizabeth.

“I didn’t say I didn’t like it. It’s fine, really,” we replied.

“You don’t have to say anything. You’re no good at poker and no good at pretending,” responded Elizabeth.

Elizabeth has decided to buy an apartment in Paris. We did the math. It doesn’t seem to make sense. We can rent a nice apartment for half as much as we pay in London. And the same apartment that we can rent for $5,000 costs more than $1 million – not to mention another couple hundred grand for a new kitchen and new bathrooms.

“Why put in a new kitchen?” we wanted to know. “This one looks perfectly fine. And what’s wrong with the bathrooms?”

Elizabeth looked at the young woman who was showing the apartment to us. Both of them rolled their eyes. Some instinct seems to tell women when they need new bathrooms and new kitchens; it was not evident to us.

And, some instinct seems to lead them to want to buy an apartment in the first place. If we were able to earn even a modest return on the money we would otherwise use to buy an apartment, we’d have enough income to pay the rent and have a little left over to go out to dinner. Buying doesn’t seem to make sense.

“I’m tired of paying rent,” said Elizabeth. “Besides, I want to be able to fix it up in my own way.”

She is still looking.

A Congressional Tantrum 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.

"I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crisis rather than a policy foresight that will force change." – Paul Volker

How long can the United States continue with an ever rising trade deficit? How far can debt rise? Will it end, as Paul Volker, former Chairman of the Fed stated above, in a financial crisis? Will it end as a soft depression as Bill Bonner suggests or is it, as the team at GaveKal projects, different this time?

Over the next ten to twelve years, we will see three recessions that will slowly move the average price-to-earnings ratio of stocks to historic lows. Rising oil and energy prices will be a main culprit of both the slowdown in the economy and an increase in inflation. Ever-increasing monetary inflation will, in fact, trigger a huge increase in all commodity prices, as well as a decline in bonds. Asset inflation will show up in the housing markets as home values continue to skyrocket. The dollar will continue to weaken against major foreign currencies. The current war will become increasingly unpopular, and the next administration will be forced to withdraw troops, under the guise of declaring victory. The American voting public will be split as never before, with major patterns in voting habits making a generational change. The newspapers will continue to write about how an Asian country will dominate the world economically in less than a few decades.

Following this period of malaise, there will be an amazing cycle of new technical innovation that will spark yet another major bull market. The new technologies will change the world in ways that simply cannot now be imagined and will lead to whole new industries, putting amazing new power and abilities into the hands of individuals and governments.

Trade Deficit Debate: 1970

The preceding scenario would, in fact, all come to pass. Except that the year was 1970 and not today. The forces that have changed the world in the decades following 1970 were only written about in science fiction and a few obscure books and journals. Who dreamed of the Internet in 1970? Who could envision that the Berlin Wall would come down in 1989? That Japan would not, in fact, dominate the world of economics and overwhelm the United States? Or that the China of Mao would become a capitalistic growth machine and that the USSR would break up? A personal computer on every desk and more computing power in an automobile than existed in the largest computers of the time? A globalized world economy? The prospect that a falling population (and not overcrowding) would be a problem, or that a Green Revolution would mean enough food for all (except where governments kept out a free market)?

In the 1970s, the mood of the country was decidedly negative. Japan was eroding our manufacturing base and unemployment was increasing. Reagan spoke of the Misery Index in his race against Jimmy Carter, which was a combination of inflation and unemployment.

And yet it all changed. In fact, the one constant in the modern world is that the pace of change is accelerating.

The above section comes from the beginning of my personal chapter in Just One Thing called The Millennium Wave, but it makes a good introduction to today’s topic as well.

In the late 70’s and early 80’s, there was a concerted sense of doom and gloom pervading the markets. Many urged that we stock food and emergency supplies, buy gold and silver and sell stocks. We had watched as Japan eroded our manufacturing base. Millions of jobs went offshore never to return. "Where," many asked, "would the jobs of the future come from?" America was in decline.

The correct answer then, as it is today, was "I don’t know from where they jobs will come, but they will." And come they did, as American entrepreneurs created whole new industries.

But that was then. Where are the economic miracles today that will save us from ourselves? Does the massive debt we are accumulating; both internally and abroad, matter?

Trade Deficit Debate: There Will Be a Rebalancing

I don’t believe that we can borrow our way to prosperity. Ultimately, as I will try to make clear, and I think I have stated consistently over the past few years, there will be a rebalancing. But I do not think it will lead to a depression, soft or otherwise. It will be Muddle Through. And after that period of rebalancing, I think we will see another great boom, probably starting then middle of the next decade.

Also, while it appears that ‘a machine at the Fed which simply grew the money supply at a reasonable rate of growth, coupled with a federal government that ran slight surpluses’ is indeed a fantasy, given today’s reality, it is my personal one. Would that it were so. But we invest in reality, not what we wish were true.

Now, let’s be clear. Muddle Through will not necessarily be fun. The 70’s were times of Muddle Through. Few would willingly revisit those economic times. And things changed dramatically from 1970 until 1990, and even faster after that. I think the next period of change will happen at a much faster pace.

But free markets and entrepreneurs adapt to new conditions. That is what happened in the 70’s and 80’s and 90’s, and what will happen in the future financial crisis that Volker speaks of. And I believe he is right. There will be a series of crises. But I think we have had a number of crises over the past 35 years and somehow we seem not only to survive, but also prosper. That is not to diminish the pain felt by many during those crises, or the losses in investment portfolios.

The argument that Bonner, Marc Faber, Steve Roach et al make is that the United States is living off of the kindness of strangers. It is the savings of the rest of the world, and primarily Asia, which finances our massive trade deficit. I argue that it works both ways, as they have become dependent upon the U.S. consumer to buy their products and keep their factories humming. It is this symbiotic relationship that has allowed the United States to run such massive deficits without a collapse of the dollar.

I wrote almost three (or maybe four) years ago that no country had ever seen their trade deficit rise to over 5% of GDP without a 30% revaluation of their currency. This was (and still is) a great part of my bearish stance on the dollar. Yet today we now run a trade deficit of almost 7%. The trade deficit is growing much faster than GDP. This is clearly an unsustainable trend. But how long can it last?

Many analysts, including me, correctly point out that it is in the best interests of the various nations to take dollars to keep their factories going. Further, dollars are not worthless. They can buy a lot of things like stock, homes, factories and assets in the United States, arguably one of the safest places in the world. Further, U.S. assets are growing faster than our liabilities. On a balance sheet basis we are in a good shape.

But Bonner correctly points out that at some point many nations of the world (read Asia) will start to wonder what they should do with all those dollars in their vaults. Those foreign dollars are now growing at $700 billion plus a year. At the rate of $69 billion last October (latest month data) it is well on its way to over $800 billion. Is there not a limit? The answer is "of course there is." (Though I should note that foreigners bought $107 billion of U.S. securities in October, an all-time high. Whatever the limit is, it seems we are yet a long way off.)

I wrote last year that various (primarily Asian) countries want to keep their currencies cheap relative to the dollar so they can be more competitive than their neighbors. It is competitive currency devaluation, plain and simple. Yet, each country’s central bank knows that ultimately those dollars are going to fall at some point. I pointed out it is like the children’s card game Old Maid. No one wants to get stuck with it at the end of the game.

Trade Deficit Debate: Do They Matter?

So, bottom line. Do trade deficits matter? Yes, in the long run, but probably not next year or the year after that. And they primarily matter to currency valuations. Please note that currencies fluctuated up and down 30% or more in the 80’s and 90’s and the large majority of the country did not notice. Has Europe wilted because the euro is down 40% or so? So "matter" is a relative term. But it should be positive for the gold bug crowd.

Because it is in the best interest of all parties concerned, the U.S. trade deficit is going to last a lot longer than most people think. The Asian countries hope that they can create their own consumer classes and slowly wean themselves from the U.S. consumer, allowing the dollar to fall gradually.

Gradually is probably not in the cards. It will be in fits and starts, with some long rallies to scare the dollar bears, like we have seen recently. I hope Volker is wrong. It would be a nice world if policy could manage a smooth transition. I strongly suspect he is right. It will be a series of financial crises that will push the dollar lower coupled with a Muddle Through Economy. During these crises and recessions, we will see consumer spending slow and savings increase which together will bring down the deficit.

Regards,

John Mauldin
for The Daily Reckoning

December 20, 2005

John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. As well as being a frequent contributor to Capital & Crisis and Strategic Investment, Mr. Mauldin is a New York Times best-selling author with a unique ability to present complex financial topics and make them understandable to the lay reader with insights into the current economy and hedge fund industry. His latest book, Just One Thing, is due out in December.

"I started selling these lots much too cheap," began a neighbor in Nicaragua. "I was letting these beachfront lots go for $30,000 to $50,000. But that was before this big boom in America got underway. I built condos on the ocean, too, and sold them for $150,000. That was only three years ago…no, only two years ago. But I resold one of them last week for $279,000."

Property buyers in Nicaragua – as in Florida and California – seem to have spent too much time in the sun. They’ve become feverish.

"Even the ‘B’ lots – you know, those that aren’t on the beach – are selling. We’re almost out of them. And I’m amazed they would sell at all. It’s low land. And when it rains, the whole place is underwater. My tractors got stuck three times during this last rainy season. But the strangest thing was this guy who wanted to buy one of the back lots. He came during the rainy season, so I didn’t want to show it to him. Because it was under about a foot of water. Luis came to me and said he wanted to borrow the tractor. I asked what for. He told me the client wanted to see the back lot. We could only get in there on the tractor…and even then I was afraid it would get stuck. But he got on the tractor and went to look at the lot and bought it."

People occasionally make a mistake and buy a lot that is underwater. Sometimes they get conned or swindled and end up with a waterlogged lot. But a real bubble market turns swindlers into honest men. They can tell the truth and still make a sale; the customer swindles himself.

The bubble may be over in North America, Australia and Britain. But new trends reach the tropics slowly, as if by steam packet. For now, developers in Latin America are selling condos, houses and underwater lots without hardly trying.

And perhaps the buyers aren’t such fools, after all. Your editor bought a parcel down the coast a few months ago. The price was exorbitant by Nicaragua standards. But compared to the rest of the world, it was a bargain. Even $279,000 for an ocean front condo would leave change in a Miami-based buyer’s pocket. And, of course, other costs are lower too – cleaning, gardening, and dining out. Everyday that our family spends in London costs a fortune. We cannot go out to dinner without spending at least $100…usually more. We take a taxi across town and easily pay $40. A cup of coffee and a croissant sets us back $15.

But here…our wallets mildew from lack of use. There is nowhere to go…scarcely a thing to buy…and nothing to do that costs money. We can play in the surf…ride horses…sunbathe…play tennis…read…write…doze… none of it costs much money. We probably save $50 a day just by being here. In a month, we have saved nearly $1,500 – about enough to cover airfare.

More news, from our team at The Rude Awakening…

Eric Fry, reporting from a gridlocked Manhattan:

"We inquired…You replied. Last week, we asked you, the Rude Awakening readers, to identify gold mining companies that you believed would be attractive takeover candidates. You responded with a flood of emails."

————–

Bill Bonner, with more miscellanies…

*** Just a quick reminder: Only 11 days left to get in on our best offer of 2005 – the Agora Financial Reserve. It’s a chance for you to profit and save by getting just about every single newsletter and options trading service Agora Financial Platinum Reserve publishes for as long as we publish them – along with every single product we will launch in the future.

*** We began building this house on the beach a couple of years ago. This is the first time the family has stayed here.

"What do you think?" we asked Elizabeth.

"I think it’s very nice," came the answer.

"But where’s the pool?" Edward, 12, wanted to know.

"We don’t need a pool. We have the ocean."

"Oh…but where’s the TV?"

"We don’t need a TV, we have books."

"Oh…but at least we have Internet, right?"

"Nope…we don’t need internet. We can write letters."

"Oh…I want to go home."

*** The boom in property prices in Latin America worries us. We like owning real estate in Nicaragua. But we like owning it because it has seemed under priced as well as underappreciated. When it becomes less under priced, it is less attractive to hold it and more attractive to sell it. But we’ve become attached to our Nicaraguan properties as if to an old pair of shoes; we hate to throw them out. Elizabeth even wants to buy more:

"We really should buy that lot next to us. Look, we’ve already invested a lot of money on our house. We want to be sure we can enjoy it, right? Well, why not try to buy up some extra lots around the house so we’ll be protected."

"But those lots are already twice as expensive as they were two years ago," we protest.

"Well, you should have bought them two years ago. Besides you’re always saying you can’t predict the future. For all you know they’ll double again in the next two years."

"Yes…we can’t predict the future…that’s why we insist on only buying things that are cheap."

"But how do you know when this is cheap? Even after doubling, this place is still not half…no, barely a 10th of prices in some areas of the United States, and it’s much more attractive. And it’s really not a question of money anyway. What’s the point of making money? It’s so you can live the way you want. After the children are all in college we’ll be able to spend more time down here. We won’t want to look out at the next-door lot and say to ourselves: if only we had bought that lot 5 years ago.

"And I’ll tell you something else…let’s say we change out minds. Well, we can always sell the lots later. But we can’t always buy them later."

"Maybe so…" we replied lamely, "maybe we could sell them later. But not necessarily for the same price."

"That’s right…maybe they’ll be less expensive. Maybe they’ll be more expensive. Since you don’t know either way, you have to ignore that point altogether. I don’t know why you brought it up…"

Where do we go from here? 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.

Where GaveKal sees a rising dollar, Bonner and Wiggin see The Demise of the Dollar (the title of a separate book by Wiggin). Where GaveKal sees promise and positive benefit in a negative balance of trade, Bonner and Wiggin see hubris and peril. Is it an Empire of Debt about to go the way of all empires, or into a Brave New World? Let us make no mistake, these are polar opposite views. And where you come down makes a large difference in how you manage your investment portfolio, not to mention how you order your future. This will make for an interesting, if not altogether fun, letter. Warning: you are about to enter a major doom and gloom zone.

There are two stories in Empire of Debt. The first is the traditional argument of the Austrian economic school. You cannot forever run trade deficits. Eventually your currency will collapse, as people will not want any more of it.

"The economy in its entirety must continue to decline so long as more is being consumed than produced, and some part of consumption therefore takes place at the expense of the existing capital stock." – Friedrich August von Hayek (Nobel Laureate, 1974)

But the evidence of that decline is not yet present. America and its currency seem to continue to prosper, even when no other nation has ever run such huge deficits without seeing a major, if not disastrous, currency revaluation. How can this be?

Empire of Debt: Can We Borrow Our Way To Success?

Can we in fact borrow our way to success? Rather than save and invest in new capital production, we ship production of our goods and now even our services offshore, and hope other nations will finance our debt.

"As the Anglo-Saxon economies lost their competitive edge in manufacturing, they tried to make up for it by encouraging consumption. This is the biggest fraud of all," write the duo in Empire of Debt.

"At first, higher consumption feels good. It is like burning the furniture to keep warm; it feels good for a moment. But the sense of well-being is extremely short-lived. When people borrow and spend, they feel as though they are getting richer – especially when their houses are rising in price. The increased consumption even shows up, indirectly, in the GDP figures as growth. But you don’t really become wealthier by consuming. You become wealthier by making things you can sell to others – at a profit. The point is obvious but, at this stage of imperial finance, it was inconvenient."

You cannot borrow and consume your way to riches. Yet our national debt – private, corporate and public – just keeps soaring. However you want to measure it, in absolute terms or as a percentage of GDP or income, debt is up and continues to climb. The low interest rates engineered by the Federal Reserve has only encouraged consumers to take on more debt.

So, one of the main themes in the book details how the increase in debt in America, combined with both trade and government deficits, must end in tears. One cannot spend oneself into riches, whether as an individual or as a country.

This is a fairly straightforward subject, and one with which many readers will find themselves nodding in agreement. It has been the way of the world since the Medes were trading with the Persians. If you do not produce more than you consume, eventually you will end up in poverty, or at the very least, in lesser economic circumstances.

But how did we get here? How did we get to a place where we run $700 billion(!) trade deficits? How did we arrive at a time when foreigners own an ever-increasing percentage of U.S. debt, where savings in the United States is negligible and we consume some 70-80% of the rest of the world’s saving so that we can continue to consume? We are beholden to the kindness of strangers – specifically China and Japan. The authors contend that if they pull the plug – if they stop buying our debt – our currency will collapse, our interest rates soar and our housing market collapse, sending us into a deep recession.

Empire of Debt: Seeing Ourselves As an Empire

And thus we arrive at the second, and far more troubling theme in the book. It pricks at our national conceits, at the very value and beliefs that we as Americans hold about ourselves. We (or most of us) see ourselves as the good guys. Bonner and Wiggin see that view.

Bonner sees the United States as an empire. That in and of itself is not exactly a new thought. Many hold that line of thinking, and do so proudly. Pax Americana makes the world a better place. Niall Ferguson contends that it is all that holds the world back from another Dark Ages. Someone has to order the world and make people and countries play nice. If there is a real problem, who you gonna call? The French? Get real.

For Bonner, being an empire is not a good thing, even though he readily admits that America is not the traditional empire of old. All empires must come to an end. So how will the American Empire end? For Bonner, it is in debt.

Full disclosure: Bonner and Wiggin are libertarians. They are advocates of a minimalist government. And they also do not believe in nation building. They believe that government intervention into problems causes more problems, rather than solves them. And that specifically includes military and central bank intervention.

"… If you deny that the United States is now an empire, you are as big a fool as we were. For a very long time we resisted the concept," write Bonner and Wiggin in their introduction. "We did not want the United States to be an empire. We thought it was a political choice. We liked the old republic of Jefferson, Washington, the U.S. Constitution…the humble nation of hard money and soft heads; we didn’t want to give it up. We thought that if the United States acted as though it were an empire it was making an error.

"What morons we were. We missed the point completely. It didn’t matter what we wanted. There was no more choice in the matter than a caterpillar has a choice about whether to become a butterfly.

"This was an important insight for us. Until then, all of the blustering and slapstick pratfalls on stage seemed like "mistakes." Why would the United States run such huge trade deficits, we wondered. It was obviously a bad idea, the nation was ruining itself. And why would it launch an invasion of Iraq or begin a war on terror–both of which were almost certain to be costly blunders. It was as if the United States wanted to destroy itself – first by bankrupting its economy, and second by creating enemies all over the globe.

"Then, we realized, that of course, that is exactly what it must do. We repeat, people come to believe what they need to believe when they need to believe it. America is an empire; its people must think like imperialists. In order to fulfill their mission, the homeland citizens had to become what George Orwell called ‘hollow dummies.’ An imperial people must believe that they deserve to be the imperial power – that is, they must believe they have the right to tell other people what to do. In order to do so, they must believe what isn’t true – that their own culture, society, economy, political system, or they themselves are superior to others.

"It is a vain conceit, but it is so bright and so big it exercises a kind of gravitational pull over the entire society. Soon, it has set in motion a whole system of shiny vanities and illusions as distant from the truth as Pluto and as bizarre as Saturn. Americans believe they can get rich by spending someone else’s money. They believe that foreign countries actually want to be invaded and taken over. They believe they can run up debt forever, and that their debt-laden houses are as good as money in the bank. That is what makes the study of contemporary economics so entertaining. We sit at our telescopes and laugh like a divorce lawyer looking at photos of a rich man in flagrante delicto; we know there’s money to be made."

But America is not an empire in the traditional sense. The Mongols or Romans conquered and demanded taxes, (a rapacious 10% or so). The British and French took commodities and cheap goods. Americans send an army and then pay hundreds of billions to the conquered.

Empire of Debt: How We Became an Empire

How did we become an empire? Bonner points to its beginning in 1913, when both the income tax and the Federal Reserve were created. These were the building tools, which could finance an empire. What tribute does the American Empire require? If you use our dollars, you have had a depreciating asset over time. The dollar will buy a mere nickel’s worth of what it did in 1913.

The second major event on the road to empire was Nixon closing the gold window, allowing the Fed and the government room to manipulate the currency as they saw fit. And of course, the New Deal, deficit financing and a host of other government solutions all contribute.

In the same way that investors thought that tech stocks would only go up in 1999, or gold in 1979, Bonner and Wiggin see a country that thinks that its stock can only rise. Since that has been the case for 225 years, why should it be different now?

Yet, they quote, "The U.S. suffers from…structural deficits that will limit the effectiveness and duration of its crypto-imperial role in the world," explains Niall Ferguson. "The first is the nation’s growing dependence on foreign capital to finance excessive private and public consumption. It is difficult to recall any empire that has long endured after becoming so dependent on lending from abroad." (Niall Ferguson, "The End of Power: Without American Hegemony the World Would Likely Return to the Dark Ages," Wall Street Journal, June 21, 2004.)

And thus we come to it. To Bonner and Wiggin, America is on a course to a soft depression brought on by debt precisely because we have become an empire. We have spent the income of future generations in order to consume today, amassing a staggering debt that grows ever larger. We have obligated our children to pay a Social Security and Medicare burden that they simply will not have the means to pay as things currently stand. The generational contract will be broken because it cannot be paid.

This is not your ordinary run of the mill doom and gloom. It captures a whole new level, for it is an inevitable doom. We are slouching toward an evening in America, unaware of our own fate. Thus have all empires ended, either with a whimper or a bang. They make a good case. The question is, can we ignore it? Are they wrong, or will somehow things be different?

John Mauldin
for The Daily Reckoning

December 06, 2005

P.S. Next week, we will look at the numbers surrounding our debt, and the not surprising answer that Empire of Debt offers: buy gold. Plus, they have a few more thoughts on ways to profit and enjoy the ride.

Not much happened in yesterday’s markets. Of course, not much has happened for a long time. This leaves most people thinking that not much will ever happen. The Dow will be over 10,000 forever. The dollar seems stable at 1.18 versus the euro. And why would you ever have to pay more than 6% for a mortgage loan?

But two things happened yesterday that might be significant. First, oil seemed to end its correction with a move back towards $60 a barrel. Second, the price of gold went up again to over $512 per ounce (Feb. contracts).

These things are significant because in the happy picture of America’s finances and the world economy, they shouldn’t be there. It would be like a man with a turban on his head saying mass at Notre Dame, or a sour smell from a bowl of yogurt. Something is rotten, they tell us.

The accepted view of America’s economic situation is that it is enjoying strong growth that – thanks to its dynamic economy and enlightened central bank – is not merely sustainable, but eternal. People expect GDP growth of 2% to 5% annually…with inflation between 2% and 3%, and property prices rising somewhat faster.

Gold points an old, gnarled finger at this pleasant scene and mutters, "It ain’t necessarily so."

Oil, too, seems unwilling to go along with the Fed’s gag. When the price seemed to peak out a month or so ago, economists breathed a sign of relief. "At last," they said, "the crisis is over. Oil will go back down to where it is supposed to be: under $50 a barrel." But yesterday, it looked more like the correction was over. Instead of continuing to go down, oil turned around and headed back up. "It ain’t necessarily so," says oil.

Of course, if you look carefully you will see a lot of other things saying the same thing.

The Bush Administration is puzzled as to why it doesn’t get more credit for such a healthy economy, writes Paul Krugman in the New York Times. You already know why it doesn’t, dear reader: the economy’s health is largely a statistical illusion.

"The president made an appearance in the Rose Garden," explains Krugman, "to hail the latest jobs report, yet a gain of 215,000 jobs would have been considered nothing special – in fact, a bit subpar – during the Clinton years. And because the average workweek shrank a bit, the total number of hours worked actually fell last month."

"Back in August the Census bureau released family income data for 2004," he continues, "It should have been a good year…the economy grew at 4.2 percent, its best performance since 1999. Yet most families actually lost economic ground. Real median household income – the income of households in the middle of the income distribution, adjusted for inflation – fell for the fifth year in a row. And on key source of economic insecurity got worse, as the number of Americans without health insurance continued to rise."

"Never mind the GDP numbers," Krugman concludes. "Most people are falling behind."

The numbers are not in for 2005, but we are sure they will show the same thing: for the sixth year in a row, real median household incomes are going down.

And yet, the economy is supposed to be healthy, dynamic and growing.

It ain’t necessarily so, is it?

More news from the pundits at The Rude Awakening…

————–

Eric Fry, reporting from Manhattan:

"’The bull market in gold is still young,’ declared Michael Martin late last week. ‘I would be buying every dip on the way up…just like tech stock investors did throughout the 1990s.’"

————–

Bill Bonner, back in London with more flotsam and jetsam…

"Outsourcing. Offshoring. That’s all we hear about in the mainstream media. And they are all falling over each other to report news of the bigwigs outsourcing and offshoring to India," Sala Kannan tells us.

"J.P. Morgan announced yesterday that it plans to have nearly one-third of its investment banking back office and support staff offshore by the end of 2007, and would achieve this by doubling its head count in India. That means that by 2007, J.P Morgan will have hired nearly 9,000 people in India.

"BusinessWeek recently published an enthusiastic article titled, ‘Intel’s Eager Passage to India.’ According to the article, Intel, the world’s largest semiconductor maker, has 2,800 employees in India and will spend $800 million over the next five years to expand its Indian operations.

"Makes you want to run out and buy an Indian outsourcing play, doesn’t it? DON’T!

"Indian outsourcing plays won’t make you a dime. They are overvalued. The average Indian IT company has a lofty 40 P/E. And the very fact that the mainstream media are all over these stories is enough proof to be bearish on Indian outsourcing.

"The IT sector is no doubt generating income, paying taxes and spending its profits on cars, houses, etc. Essentially, money is flowing out of IT and into other sectors of the economy. So instead of investing in IT, follow the money out of Indian IT and into other sectors.

"Think of it as a champagne tower. Just like champagne overflows from the first glass and fills the others below it in a champagne tower, money overflows from the IT sector and fills the other sectors below it."

*** All assets – except stocks – seem to be rising, especially at the top end. Christies reports that art prices have hit new records, after rising as much as 40% over the lat year. Diamonds are also soaring in price – particularly big ones…mansions, too.

We have no data on this, but our guess is that while inventories of "McMansions" are backing up, the real mansions are selling quite well. The difference is that the McMansions are bought with debt. Real mansions are bought without mortgages. Bonuses on Wall Street, and in London’s "City," are huge. Everyone who works in finance or the shelter trades is making money. A friend here in London tells us that he was staggered when he went to put a new kitchen in his country house:

"Well, one thing led to another. We have to fix up an apartment over the garage so we’d have somewhere to stay while they were redoing the kitchen. And then, when we got into it we decided to update the plumbing…and why not do this and that. But in the end, the new kitchen is costing me about $400,000!"

Now the plumber has more money, and the people who put in granite countertops, and the builders. All over town, the money oozes out. GDP rises. Everyone is richer, right?

Well, our friend has a nice kitchen, but he has $400,000 less in savings. The money has been converted into a consumer item: a better kitchen. And then consumed by plumbers, masons, electricians and so forth.

Is this how people get rich? Nope.

*** And now for something really interesting. We have always wondered what happens when you get your head cut off. Do you black out immediately? Or, do you have some brief time to reflect on life without a body? Do you have time to curse the executioner? Thankfully, the Daily Mail provides answers:

"Generally…it appears to take around 30 seconds to lose consciousness after decapitation. We know this from the French Revolution and the liberal use of the guillotine. The condemned were asked to blink if they were still alert after their heads have been removed from their body. Records show that it took between 20 and 30 seconds for the heads to stop blinking."

Same As It Ever Was 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.

For readers in the middle of this conversation, we are in a series on the debate held at a London restaurant between Charles and Louis-Vincent Gave (father and son) and Bill Bonner. The Gaves openly declared that "This time it’s different," much to Bill’s amusement. We all know that it almost never, ever is. They make their argument in a book called "Our Brave New World."

The next thing that GaveKal argues is that monetary policy no longer works like it used to. "In the wake of the Asian Crisis, lower rates are more stimulative to supply than demand while it used to be that lower rates were more stimulative to demand."

This is a subtle argument, but part of an overall theme that we are in a deflationary world. Bonner would agree, but where he sees a negative aspect of deflation, they see a deflationary boom. Readers of Gary Shilling would recognize this position. Shilling has maintained for years that we will enter a period of what he calls good deflation.

At its roots, a deflationary boom exists when supply is structurally ahead of demand. Prices drop, and in a classic world, when prices drop, demand rises, thus stimulating even more supply.

Our Brave New World: The Job of Central Bankers

This, they point out, makes it easy for central bankers, if you assume the job of central bankers is to keep inflation under control. They do not have to worry about the supply side of the inflation model. Inflation can be created by not enough supply to meet demand. But when there is always "more stuff" coming into the market, inflation does not result from supply side problems.

That means that central bankers need only worry about the demand side of the equation causing inflation. Thus, raising rates will lower demand, taking away the demand driven inflation. If they need to stimulate demand, as they wanted to in 2001-02, they simply lower rates. But here is the GaveKal twist:

"In terms of managing demand, the Fed may have overdone the demand stimulation in 2001-04, but an important lesson was learned: low rates not only stimulate consumption in the US, but capacity expansion abroad even more. For a while, we get a window where demand surges (i.e.: US housing cycle, energy) and people believe we have entered an inflationary boom. For a brief period, it appears that demand has caught up with supply. But, monetary demand stimulation at the core also creates supply stimulation at the periphery. And while this is going on, investment in capacity looks like demand.

"At some point however, the rise in commodity and house prices we have witnessed in recent years will likely be viewed more as a reflection of capacity growth around the world, not true demand.

"Because low rates are a reflection of the deflationary backdrop, not the cause, the Fed simply can not lean into demand too hard by raising rates aggressively; otherwise they risk a real deflationary bust. The Fed thus has to raise rates gingerly and talk tough – walk hard, but carry a small stick. And since prices don’t structurally take off, core inflation measures around the world stay tame.

"Whatever central bankers want to do, they cannot change the reality that supply is in excess of demand. So the complexion of activity is decent volume growth but muted prices. This likely means that the next time the Fed has to lower rates aggressively, the curve won’t be as steep as the last go around. In our old MV=PQ framework, when curves are steep, currencies fall, and deficits widen, companies can monetize higher prices. Income statements are inflation pass-throughs. However, investors usually don’t like to pay a lot for that (which is why multiples have fallen over the last few years).

Our Brave New World: The Crutch of Price

"Today, those forces are in reverse. Companies cannot rely on the crutch of price; companies have to monetize volumes. This is much harder to do; and investors are willing to pay a premium (i.e.: Apple) for companies that can do it."

By "rely on the crutch of price," GaveKal means that companies simply cannot raise prices to increase profits. They have to sell more "stuff" at lower prices to increase total profits.

This is the chicken-and-egg analogy, but an important distinction. Yes, the Fed did want to stimulate demand when they lowered rates. But they also made cheap money (with the help of other central banks, and especially Japan) available WORLDWIDE for increasing production. Thus, China has some 1,000 ball bearing companies when it needs, maybe, 10. Each day, the managers of those 1,000 companies wake up trying to figure out how to get to be big enough to be one of the 10 who will survive. And that means growing even more capacity, which is not really needed. They do this by borrowing money, getting foreign investment, offering lever lower prices, etc. And since rates are low and the money is easy to come by, they have every incentive to do so.

It is the same for chips and copper wire and appliances and, well, just about everything. And the developed world responds by letting the developing world (not just China!!!) do the low profit manufacturing and keeps the profitable design and marketing parts of the business. And this results in a trade deficit.

We shall see that Bonner, et al, do not like the dollar asset standard. Good old gold is what we need as a basis for money. Yet GaveKal not only asserts that a dollar asset standard is developing, but that it is superior to gold. Quite simply, they argue that since gold cannot grow at a fast enough pace to maintain global growth, it has to be replaced, otherwise we revert to a world where consumers lose and governments dominate by their power of controlling gold flows. Now, let’s turn to page 109 in our hymnbook and let them explain how they see their Brave New World developing:

"If we assume that a new part of the world is getting richer (China, India, Russia, Brazil, etc.), then we should probably assume that some entrepreneurs in those countries are making it big. This assumption is not a stretch; there is enough anecdotal evidence to support it (if you doubt that some new entrepreneurs are making it big, go to the Louis Vuitton store in Shanghai on a weekend). If we further assume that, in the countries getting richer, we will start to witness the emergence of institutional savings (pension funds, mutual funds, family offices, etc.), then we should expect big ’savings flows’ from the rapidly growing developing world into the Western world.

"In simple words, the emerging markets’ newly rich will feel like investing a part of their newly created wealth in regions of the world where property rights are well protected and where there is a rule of law. The excess trade balances earned by the ‘industrial world’ have, in fact, little choice but to be reinvested in the assets of the ‘creative world’. The pension funds of the ‘industrial world’ will buy the companies which give their countries work. The successful individuals in the ‘industrial world’ will also buy real estate in the ‘creative world’ (because it also happens to be the ‘fun world’).

Our Brave New World: The Two Parts of Balance of Payments

"This implies that the assets in the ‘creative world,’ and especially the prestige assets will always border on the overvalued. Similarly, given the ability to change a producer if he becomes a little bit too demanding, asset prices in the industrial world will remain a little bit undervalued at all times…Which brings us to the following point: balance of payments consists of two parts:

"1. The Capital Balance: if the above holds true, that part will always be positive for countries with well developed financial markets.

"2. The Current Account: since the two parts add to zero (by construction) it means that the current account in countries with well developed financial markets (US, UK, HK etc.) should always be in deficit, and massively so…

"Taking this a step further, we can assume that, as a result of the constant capital flows, the countries with a well-developed capital market will have an overvalued currency and a very low level of long rates. Which in turn leads to robust real estate markets (see chapter and higher asset prices.

"We call this ‘the dollar asset standard’. Basically, diversified and safe assets in the Western world replace gold as the standard of value in the eyes of new savers in Asia, Latin America or Eastern Europe.

"The first implication of this new ‘dollar asset standard’ is that overvalued currencies, combined with a low cost of money (i.e. low barriers to entry), will prevent anybody in the ‘developed financial market world’ from making any money in industrial goods. In turn, this development will ultimately force companies in the developed financial market world to move to the ‘platform company’ business model, specializing in design and in marketing, and letting someone else produce the goods.

"But this is where it gets interesting: once they make the switch to the ‘platform company’ model, a number of companies will likely realize that they should domicile their research and marketing activities in countries with low marginal tax rates, both for their shareholders and their employees.

"To some extent, this has already happened in the financial industry. On any given day, the biggest foreign net buyer or seller of US Treasuries is the Caribbean Islands. Now needless to say, the Caribbean islanders are not amongst the world’s largest investors; but the hedge funds domiciled there most definitely are. So the ‘efficiency capital’ of the world, which used to be domiciled in big investment banks in the world’s financial centers (whether London, New York, Frankfurt, Tokyo…) has now re-domiciled itself in hedge funds whose legal structures are in the Caymans, Bermuda, the British Virgin Islands etc. The tax revenue on the ‘efficiency capital’ is now lost for the US, the UK and others…and there is little they can do to gain it back.

"And it’s not just in finance that this is happening. Hong Kong Land, a property developer is incorporated in Bermuda. Electronic Arts, one of the world’s biggest video game designers is incorporated in the Caymans…. As an increasing number of companies move to the ‘platform-company’ model, it is likely that the top talent will want to work, or at least be taxed, in low tax environments. This will lead to a collapse in tax receipts in countries that do not adjust to this new model. In the new world towards which we are rapidly moving, income taxes will becoming increasingly voluntary and governments will have to get their pound of flesh through property and consumption taxes instead. This should lead to more efficient (i.e. downsized) governments all over the Western World. The platform companies might end up killing off the Welfare State."

This sounds like James Dale Davidson and Lord Rees-Mogg in their important book written a few years back called The Sovereign Individual, although GaveKal comes to the same end from a different road.

And it is an idea to which I subscribe, though for different reasons. It will not just be the pressure from platform companies wanting to avoid taxes that will precipitate that change. I would make the argument that the current generation (in nearly every country in the developed world) and our forebears have written a check in the names of our children, which they will not be able to pay. By this I mean our social security and pension programs. And if they cannot pay it, they won’t. The social contract between generations and governments is going to be re-written in the next 20 years.

We live in interesting times.

Regards,

John Mauldin
for The Daily Reckoning

November 29, 2005

P.S. Today, we concluded the GaveKal arguments in Our Brave New World. Next week, we will turn to Empire of Debt, looking at Bill’s and Addison’s arguments.

Then I will share my view on the topic. It will surprise no one that I think the truth is somewhere in the middle. Things are in fact different, yet we will have to find a balance. That a balance and a squaring of the balance sheet may come from new and different forces than in the past will make things seem both different and the same. It is a rhyme, not a repeat. It is Muddle Through, not a depression, soft or otherwise.

John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. As well as being a frequent contributor to Capital & Crisis and Strategic Investment, Mr. Mauldin is a New York Times best-selling author with a unique ability to present complex financial topics and make them understandable to the lay reader with insights into the current economy and hedge fund industry. His latest book, Just One Thing, is due out in December.

Another day, another dollar.

Today’s dollar ain’t what it used to be. It ain’t even what it used to be yesterday. We have a hunch it ain’t what it will be tomorrow, either.

Yesterday, the dollar fell against the euro and the yen. Don’t be alarmed, dear reader; the small rise in foreign currencies was nothing important. The news from Europe is that traders are betting that the European Central Bank will raise rates, and/or that the U.S. Central Bank will stop raising them.

More important was the news from Washington and Asia. In this morning’s trading in Asia, gold jumped over $500 an ounce. It is almost twice as expensive as it was when we recommended it to you more than five years ago. A double in five years? What’s so great about that, you’re probably wondering. Google went from $85 to $428 (yesterday) in a matter of months.

It is not pride that causes us to remind you of gold’s rise, but modesty. We have good reason to be humble. We know nothing of the future, and very little of the past. But what we do know is that every other time mankind has tried to replace gold with paper, people ended up craving gold more than ever. We see no reason why the present experiment should produce a different result.

The latest numbers issuing from Washington reinforced our faith in the customary outcome. George W. Bush will go down in history not as a great war president, we predict, but as a great debt president. In his few years in office, the feds have borrowed more than $1.05 trillion from foreign governments and banks. This is more than all the rest of the nation’s administrations put together, since 1776 to 2000.

Last month, the U.S. national debt passed the $8 trillion mark. This year’s budget deficit alone, added $319 billion to the country’s obligations. While we do not know what the future will bring, nevertheless we can put two and two together. According to the government’s own accountants, deficits will rise to $873 billion per year within 10 years. Two years more and they will be at $1 trillion per year, with a national debt edging up to $20 trillion. By 2017, annual deficits are supposed to reach $2 trillion per year.

These figures are not hard to come up with. You merely project current population and income trends into the future…along with already-legislated boondoggles, such as health and retirement programs. You end up with big numbers.

You also end up with a national currency that has question marks all over it. Eventually, those questions will be answered. Already, since being cut loose from gold, the dollar has lost more than half its purchasing power. It is bound to lose a lot more.

The price of gold will go over $1,000 an ounce, says Newmont. Maybe so.

More news from the pundits at The Rude Awakening…

————–

James Boric, reporting from Charm City:

"Joel Greenblatt is not famous…He is merely rich.

"Last week, I discovered why he is so rich. My discovery could easily put a few extra dollar bills in your pocket as well…Maybe even millions of dollar bills."

————–

Bill Bonner, back in London with more views…

*** Yesterday’s decline in the dollar was laid to the housing industry. Fewer bricks and less mortar were sold last month than analysts had hoped for. Buyers were so scarce that inventories rose to a 19-year high.

On the other hand, the piles that did sell, sold for high prices. Go figure. The median house sold for 17% more than a year ago – the biggest increase in 26 years.

Obviously, something’s gotta give. Inventories and prices cannot rise together for very long. We will take a wild guess: prices will go down before inventories do.

*** The noted empire scholar, Professor Niall Ferguson, despite being on a book deadline himself, had these kind words to say about our book: "[Empire of Debt] is a book that is certainly asking the right question about America’s fiscally over-stretched empire."

*** As you may know, before Thanksgiving we sent 537 copies of Empire of Debt to the scalawags in Washington. And then, we asked readers to call or e-mail their representatives to make sure they got the books and read the introduction (at least!).

"A reporter from Smart Money magazine got wind of our plot," writes Addison. "’What did you expect to happen next?’ she asked me this morning."

Hmmmn. That’s a good question.

As of this morning, we’ve received six form letters and one holiday card back. Most of the form letters read something like this one from Senator Mark Pryor:

"Mr. Addison Wiggin
Angora Financial (sic)
808 St. Paul Street
Baltimore, Maryland 21202

"Dear Mr. Wiggin:

"Just a note to thank you for sending me a copy of your book Empire of Debt: The Rise of an Epic Financial Crisis. I certainly appreciate your thoughtfulness and am looking forward to reading it.

"Thank you, again.

"Sincerely, Mark Pryor"

Curiously, the phrase: "I appreciate your thoughtfulness and am looking forward to reading it" appears almost verbatim in several letters.

*** One representative from Michigan writes: "Thank you for your generous gift you sent to me. The book, Empire of Debt, will make a nice addition to my collection."

But a Senator from Wisconsin warns us that he has adopted his state’s code of ethics prohibiting him any gifts because of his public position. In lieu of accepting the gift, he will put it on public display in his office, "as property of the State of Wisconsin for the enjoyment of visiting Wisconsin residents."

Public apology: We certainly did not intend to get the gentleman from Michigan in trouble for accepting gifts.

*** Finally, Addison G. "Joe" Wilson, representative from South Carolina, took the time to hand scribble a note: "I particularly like your first name!"

*** Old friends came by to visit over the Thanksgiving holiday.

"You probably should sell that farm you have," said our friend. "Northern Virginia has gotten so crowded and expensive that people are coming over to Maryland, to our area, to buy places. And they’ve got a lot of money to spend."

We did a calculation. We bought our farm, about a half-hour from Washington, DC, in 1984. We paid only about $200,000 for the land. Then, we invested as much as $300,000 in the place, building a house, barns and so forth.

Anne Arundel County has a remarkable program wherein they pay landowners not to sell their property to developers. We had no intention of selling, so we were happy to take the money – about as much as we had paid for the land in the first place. In terms of today’s gold price, this leaves us with about 600 ounces worth invested. But our friend tells us that we could sell the place – even subject to the no-development restrictions – for $2 million.

"You have to be kidding," we protested. The place is just something we cobbled together as best we could, when we had no money to speak of. It is behind an old church that burned down and a property that has become a junkyard. Even as a farm, it’s pathetic. It’s too hilly. We just keep goats on it in order to qualify for a lower property tax rate."

"Well…things have gone crazy. It’s out in the country. Your house is very pretty. Yes, it’s kind of funky. But you have 100 acres. Places like that are hard to find."

Converted to gold, the place has a market value of 4,000 ounces. In other words, in constant gold terms, the place has appreciated more than 600% in the last 20 years. And yet, it has no more real value (or utility) than it had before. Less even…we have been away for more than 10 years. The property has been maintained, but not improved. And all around, the surrounding county has been developed with houses, highways, and shopping malls all over the place…making it less attractive to us.

"We really should sell the place," we said to Elizabeth.

"Well, from an investment perspective, you’re certainly right. It seems ridiculous that anyone would pay that kind of money. We should take advantage of it. But that’s our family home – our permanent home. You built much of it yourself. And yes, you’re not the greatest builder in the world…and I’m sure we’ve learned enough now to put in plumbing that doesn’t freeze every year…and I’m sure you will never again design a solar-heated kitchen where we either roast or freeze…and those windows never worked right…and that heat pump heating system was a disaster from the first day…but I love that motto that you had carved over the front door – what was it?"

‘"Hic Domus…Haec Patria Est,’ It’s from Virgil. It means, ‘this is our home; this is our country’"

"Yes, how could you think of selling that? Besides, where will we go…after you retire, I mean. Where will we live?"

"Well, there’s always Argentina."

"Stop right there…I don’t want to hear any more. I don’t want to sell."

Our Brave New World, Part II 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.

The real danger to the platform model? Governments and protectionism. As they point out, a Dell computer says “Made in China” but it is really more accurate to say assembled in China. It is made from parts and software from a score of countries. Of course, the “trade deficit” is counted as China’s. Yet, Senator Schumer regularly bashes China, appealing to his union supporters, but fails to notice things like this. Should we also get upset with Korea and Taiwan and Russia and Sweden and the rest of the countries who contributed? We live in a world where our ability to measure economic reality is becoming more and more limited.

In a world where the U.S. government counts Microsoft physical exports as “plastic” because the disks are plastic and only worth a few dollars at most (Dennis Gartman swears he was told this by a government official who was physically counting export shipping at a port), how can we trust the numbers?

But let’s let the GaveKal guys make their own conclusions. I quote this passage at length, because it set’s up the argument and some key points:

“As mentioned [in the book], one of the first implications of the ‘platform company’ model is that industrial jobs (those close to the hearts of our bearish friends and left wing politicians) in the ‘creative world’ disappear, only to reappear in Mexico, China etc… Over time, the job market in the developed economies moves to a minority of very creative individuals who work for themselves, and a majority of fellows who work in the service industry for the creative minds and/or the tourists coming in from the industrial world….

“If we assume that a new part of the world is getting richer (China, India, Russia, Brazil, etc.), then we should probably assume that some entrepreneurs in those countries are making it big. This assumption is not a stretch; there is enough anecdotal evidence to support (if you doubt that some new entrepreneurs are making it big, go to the Louis Vuitton store in Shanghai on a weekend). If we further assume that, in the countries getting richer, we will start to witness the emergence of institutional savings (pension funds, mutual funds, family offices, etc.), then we should expect big ’savings flows’ from the rapidly growing developing world into the Western world.

“In simple words, the emerging markets’ newly rich will feel like investing a part of their newly created wealth in regions of the world where property rights are well protected and where there is a rule of law. The excess trade balances earned by the ‘industrial world’ have, in fact, little choice but to be reinvested in the assets of the ‘creative world’. The pension funds of the ‘industrial world’ will buy the companies which give their countries work. The successful individuals in the ‘industrial world’ will also buy real estate in the ‘creative world’ (because it also happens to be the ‘fun world’). This implies that the assets in the ‘creative world’ and especially the prestige assets will always border on the overvalued. Similarly, given the ability to change a producer if he becomes a little bit too demanding, asset prices in the industrial world will remain a little bit undervalued at all times…

“Which brings us to the following point: balance of payments consists of two parts:

1) The Capital Balance: if the above holds true, that part will always be positive for countries with well developed financial markets.

2) The Current Account: since the two parts add to zero (by construction) it means that the current account in countries with well developed financial markets (US, UK, HK etc.) should always be in deficit, and massively so…

“Taking this a step further, we can assume that, as a result of the constant capital flows, the countries with a well developed capital market will have an overvalued currency and a very low level of long rates. Which in turn leads to robust real estate markets and higher asset prices.

“We call this ‘the dollar asset standard’. Basically, diversified and safe assets in the Western world replace gold as the standard of value in the eyes of new savers in Asia, Latin America, or Eastern Europe.

“The first implication of this new ‘dollar asset standard’ is that overvalued currencies, combined with a low cost of money (i.e. low barriers to entry), will prevent anybody in the ‘developed financial market world’ from making any money in industrial goods. In turn, this development will ultimately force companies in the developed financial market world to move to the ‘platform company’ business model, specializing in design and in marketing, and letting someone else produce the goods.

“But this is where it get interesting: once they make the switch to the ‘platform company’ model, a number of companies will likely realize that they should domicile their research and marketing activities in countries with low marginal tax rates, both for their shareholders and their employees.”

This latter point is already happening, of course. Just this week, the Wall Street Journal ran a front-page story on how Microsoft saves billions in U.S. taxes each year by having an Irish subsidiary. Ireland has seen significant economic growth because of its low tax status, especially compared to the continental Old Europe. More and more companies are moving their operations and subsidiaries to low tax countries.

That is enough for this week. Next week we look at why the United States does not really have a cash deficit, as assets are rising faster than our trade deficit. This, according to GaveKal, can make the current deficit last a long time. Why does this happen? Also, rising incomes throughout the world will change trade and manufacturing. 300 million Chinese with cell phones? How should we then invest? Tune in next week.

And for those who think this all sounds crazy, we will then spend some with Bill and Addison, as they tell us it is never different. That there are consequences to poor economic policy and central banks playing with the money supply and interest rates, and that bubbles do not end happily.

[Ed. Note: You can get Bill Bonner and Addison Wiggin’s book, Empire of Debt here:

Empire of Debt: The Rise of an Epic Financial Crisis

You can get GaveKal’s book, Our Brave New World at www.gavekal.com. I highly recommend them both. As I said, this debate is central to our investment, political and social worlds. And don’t forget to order Just One Thing if you haven’t done so.

The Dollar Asset Standard 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.

THIS TIME IT’S DIFFERENT

A few weeks ago I mentioned a small dinner party in London hosted by Charles and Louis-Vincent Gave, the Gaves of GaveKal Research. They are quite bullish about the longer-term prospects for the world, and as we will see below, argue that something new is happening that may not rhyme with our past economic history. Long time readers know I like history. It is an old friend. It is a very uncomfortable proposition to hear things may be different, as they argue it well. Feeling like having a little fun, I invited Bill Bonner to dine with us, knowing that he takes the very opposite view. With wives and friends there were ten of us. I made certain that Bill sat next to Louis and Charles, knowing his natural inclination to sit next to the ladies which would have been more fun for him, but would have produced no fireworks.

But first, let me thank those of you who bought my new and latest book, Just One Thing, last weekend. For those of you who missed the announcement, I have gotten 11 of my friends to write a chapter on the one investment topic they are most passionate about, and of course, contributed my own chapter.

The discussion at dinner began as Charles and Louis suggested that trade deficits no longer matter. Bill’s eyebrows shot up and he rose to the occasion, coming back with his own arguments. It went back and forth for a few minutes, with your humble analyst egging all of them on. (It was good fun, and Louis was picking up the check. All in all, a most delightful meal at a very great restaurant.)

Our Brave New World: “But It’s Never Different.”

“You’ve got to be kidding,” Bill announced. “You are saying that this time it’s different.”

“That is precisely what we are saying,” shot back Louis.

Bill looked at them like he was seeing someone from outer space. “But it’s never different,” he proffered.

Then Louis gave us a copy of his new book, called “Our Brave New World” where they outline their reasoning. I knew that in Bill’s new book, Empire of Debt, which is subtitled “The Rise of an Epic Financial Crisis” he and co-author Addison Wiggin make the exact opposite argument. History will indeed rhyme and lead to a serious financial situation, destabilizing the global economy.

Now, let’s start with this quote from the introduction of Our Brave New World. It sets the table nicely.

“History never repeats itself; but it often rhymes.

“This simple fact explains why so many financial analysts, market strategists and portfolio managers like to study past economic cycles and market reactions before taking investment decisions. By studying financial and economic history, market participants are able to anchor beliefs on solid facts.

“The reason so many analysts drag their feet in admitting that history has failed to rhyme this time around is that it would lead one to the dreaded conclusion that ‘things are different this time’. But why is this a dreaded conclusion? Because anyone who has spent ten minutes on a trading floor knows that saying ‘things are different this time’ is:

1) the easiest way to get laughed out of a room,

2) the most expensive words ever pronounced,

3) the surest way to lose any kind of credibility,

“And yet, this is exactly what we aim to argue in the following pages.

“Arguing that ‘things are different this time’, we freely admit that we might end up drawing the wrong conclusions, say silly things and establish relationships where there are none. We also realize that some of our more cynical clients (say those sitting in Boston or London), might read the coming chapters and conclude that we have really been drinking the Kool-Aid. These are the risks when one ventures into uncharted territory. We accept these risks gladly, for we are convinced that the first step to successful investing is an understanding of the current world.

“Unfortunately, History is of little help to this understanding. We have to draw solely on logic, and the help of our friends and clients. With this in mind, we kindly ask that you contact us if you see a flaw in any of the arguments that we present. Again, this is a work in progress, the final aim of which is to help us understand the world we live in so that we can deploy our capital more efficiently.”

Our Brave New World: How Is It Different?

So, what makes it different this time? GaveKal suggests a number of things.

First, there is a new business model. Just as industrialists were new in the late 1700s, there is now a new model developing. GaveKal calls this new model “platform companies.”

The old model was to design or find something, manufacture it, market it and sell it. (Think Ford, Caterpillar, 3M, oil, mining.) The new model keeps just the high value added parts and ditches the rest. The new model focuses on research and development, treasury, marketing, and the business process and out sources as much of the low margin work as possible. Think Dell, Wal-Mart, IKEA, Li and Fung. Most hotel chains now do not own their properties.

The new model is to “produce nowhere but to sell everywhere….Platform companies know where the clients are and what they want and where the producers are. Platform companies then simply organize the ordering by the clients and the delivery by the producers (and the placing of their logo on the product just before delivery).”

Production is the least profitable of all the processes. It ties up capital, means a lot of volatile (and costly) inventory, it is labor intensive (and subject to all sorts of problems when there is a slowdown (unproductive labor costs) or a quick need for more product and overtime costs). The market does not give manufacturing companies the same investment multiple as they do the platform companies. Platform companies have more stable incomes and profits.

Who would you rather be? The Chinese and other Asian companies that make the iPod at a 2-3% margin or Apple who sells it at a 40% margin?

But this process means manufacturing jobs leave the developed world (the United States, Canada, Old Europe, Australia, New Zealand and Japan) and move to the developing world, primarily Asia and Eastern Europe. This is not seen be many observers as a good thing. Take for instance good friend Marc Faber’s recent writing:

“I am fully aware that some observers will argue that it doesn’t matter that U.S. companies are increasingly moving their own plants overseas, or outsourcing altogether, because the improved profits that result from the outsourcing accrue to the parent company… However, what about the long term? How beneficial is it going to be for Western industrialized companies if IBM were to lay off 13,000 people over the next twelve months in the US and hire 14,000 in India…I suppose even a non-economist could see that the movement offshore of sophisticated manufacturing and well-paid service jobs has to have some negative macro-economic consequences…”

And indeed jobs have been lost. But more have been found. Some would argue that we are seeing lower paying jobs, but the reality is that tax receipts, at least in the United States, are always and everywhere up, even as the Federal government cut taxes! No one pays more taxes than they absolutely have to. Higher tax receipts means people are making more money. Not everyone, of course.

Our Brave New World: Will the Model Pass?

Is the platform company model something that will pass or is it the new wave? GaveKal asserts that the model depends upon four things.

1. Free trade, so that products can be produced wherever costs are lowest.

2. Technological progress, especially in communications, which allows a company to decentralize its process.

3. Recurrent overcapacity in most industries, which allows the platform company to never run out of goods to sell.

4. The ability to move goods easily (needed infrastructure like airports, ports and highways).

The above items are all part and parcel of a capitalist economy. “So in a sense, ‘platform companies’ are the children of the capitalist system.”

And where does growth in a capitalistic society come from? It either comes from what is called Ricardian growth (from economist David Ricardo), or the growth that comes from a rational organization of talent, where each person contributes at his best level of skill. Countries that do not allow for free movement and advancement of its workers are less profitable than those that do. How much talent is wasted in countries that do not allow women to work, or do not educate their poor universally? Growth is clearly better when those with the best skills and services are allowed to thrive, free of protectionism. This is true whether it is on a personal level or on a country level. If China can manufacture something cheaper than is the case in the United States, then why should consumers be required to pay more? And if something costs less, then more of it will be bought. Thus Ricardian growth.

Yes, that does result in some workers losing jobs, but in a fluid and free economy, they find others. While some find jobs with less income, as noted above, incomes on average are up. And yes, we have fewer manufacturing jobs, but we are manufacturing more “stuff” than ever. We have become more efficient, as technology has made our manufacturing processes in the developed world more productive.

Then second type of growth is what Schumpeter calls creative destruction. It is the growth that comes from new ideas and inventions driven by entrepreneurs. New ideas mean new products that create whole new levels of demand. It can also mean that some products become obsolete. There was a time when my fax machine hummed all day. Now, we get 2-3 faxes a day, at most. I no longer have a home phone, as we all use cell phones. Things change. They go the way of the buggy whip.

For Ricardian growth you need low trade barriers. For Schumpeterian type growth, you need low regulations, low taxes, access to capital and the ability and right to fail. To the degree which countries encourage such things, they prosper or grow more slowly.

The real danger to the platform model? Governments and protectionism. As they point out, a Dell computer says “Made in China” but it is really more accurate to say assembled in China. It is made from parts and software from a score of countries. Of course, the “trade deficit” is counted as China’s. Yet, Senator Schumer regularly bashes China, appealing to his union supporters, but fails to notice things like this. Should we also get upset with Korea and Taiwan and Russia and Sweden and the rest of the countries who contributed? We live in a world where our ability to measure economic reality is becoming more and more limited.

In a world where the U.S. government counts Microsoft physical exports as “plastic” because the disks are plastic and only worth a few dollars at most (Dennis Gartman swears he was told this by a government official who was physically counting export shipping at a port), how can we trust the numbers?

Regards,

John Mauldin
for The Daily Reckoning

Novemeber 15, 2005

P.S. Today, we looked at some of the arguments in Our Brave New World (also co-authored by Anatole Kaletsky, the Kal in GaveKal).

It will take two weeks to cover GaveKal’s thoughts. Then we will turn to Empire of Debt, looking at Bill and Addison’s arguments.

Then I will weigh in with my own. I find there is merit on both views, but think there may yet be a third way to look at our world. And make no mistake, how you come down on this argument is critical. Because the investment strategies one would adopt if you hold these views are quite different. But wait until the series is finished before you tell me I am nuts.

John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. As well as being a frequent contributor to Capital & Crisis and Strategic Investment, Mr. Mauldin is a New York Times best-selling author with a unique ability to present complex financial topics and make them understandable to the lay reader with insights into the current economy and hedge fund industry. His latest book, Just One Thing, is due out in December.

Today, on our way to work, we were stopped by a woman dressed as a banana. It reminded us of other odd people we have been privileged to know…about which, more below.

But such is the nature of our world that strange things happen from time to time. History records many episodes of aberration and many spasms of excess. We looked at one of those curious phenomena yesterday – the bubble in farmland in the otherwise monotonous western plains during the 1880s. So feverish were the borrowers and lenders back then, and so sure were they that land prices had nowhere to go but up, that there was soon one mortgage for every two adults. Per capital, debt levels in western Kansas rose over $347, or about four times as much as the nation as a whole.

And who could argue with the speculators? Everybody knew that the United States of America was filling up. And everybody knew that these new Yankee Doodles needed to be fed. Everybody also knew that the supply of farmland was not infinite. Out beyond Kansas, the land turned so dry that you could only graze cattle on it. This was the last big patch of earth on the whole continent that had not yet been put to the plow.

And yet, by the end of the decade the rains failed, the crops failed, the mortgages failed, the bubble failed, the New Era failed, and the farmers went back whence they came. One half the population of Western Kansas left the territory, says a source quoted by Grant’s Interest Rate Observer, “as they had entered it only a few months before, each with his family and his total worldly possessions in a single covered wagon, drawn by two gaunt ponies.”

But, of course, all of that happened before the invention of the Federal Reserve System.

Money grubbing is as old as pitching woo. Speculating predates spats. Bubbles have been around since the days of Bathsheba.

By contrast, the phrase, “the Great Moderation,” entered the history books only recently.

It is meant to describe what has happened in the financial markets during the reign of the best-known civil servant since Pontius Pilate, Alan Greenspan. During his time in office, it is widely believed the sturm und drang (storm and stress) of the markets gave way to stability and predictability. It was as though a marching band had switched to playing E-Z listening elevator favorites, and the parade that normally followed – with clowns, acrobats, and soldiers in gaudy uniforms with weapons on their shoulders, and smelly crowds lining the sidewalks – had been replaced by accountants, economists, and investment quants armed with laptop computers and spreadsheets, in an air-conditioned room. The thrill went out of the whole thing, but so did the risk and surprise. With sophisticated modern financial instruments, and enlightened management, any risk can be hedged. There is no longer anyone to laugh at, they say, or anyone to feel sorry for. If a man goes broke today, it is his own damned fault.

That is the wonderful world in which we find ourselves today, or so we are told.

But that was also the world as it existed, more or less, in 1987. This was at the beginning of Alan Greenspan’s term. Then, as now, investment professionals had computers and the Black-Scholes option pricing theory. And then, as now, a lot of people were prepared to believe that investing was a science that could be modeled and controlled so as to eliminate risk. A few innovators had even come up with “portfolio insurance,” which offered investors a way to stay in the stock market without worrying about a decline in prices. Another new era had arrived for investors.

Dr. Bruce Jacobs describes how it worked:

“An actual put on an underling stock portfolio protects the portfolio from stock price declines below a certain level while leaving the portfolio open to stock price advances. Using computerized rules and program trading (again, like today), portfolio insurance aimed to replicate the behavior of a put option by selling short stock index futures.”

Dr. Jacobs also put his finger on the fly in the ointment:

“Option replication requires trend-following behavior – selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends.”

One investor could hedge his exposure. All could not. Who would be on the other side of the trade? The more the idea of “portfolio insurance” took hold, the less insurance there was. In fact, the more people tried to protect themselves from falling prices all at once…the more they suffered losses. When “Black Monday” came, Dr.Jacobs describes what happened:

“Portfolio insurers sold futures equivalent to $530 million, $965 million, and $2.1 billion in stocks on the Wednesday, Thursday, and Friday preceding the crash (SEC 1988: 2.6, 3.9). The market fell 10 percent in this same period. A typical portfolio insurance strategy would have called for the sale of 20 percent of the equities in response to a 10 percent decline.”

Then, on Monday morning…

“From 9:30-9:40 a.m., program selling constituted 61 percent of NYSE volume. Between 11:40 a.m. and 2:00 p.m., portfolio insurers sold about $1.3 billion in futures, representing about 41 percent of public futures volume (Brady Comm. 1988:36). In addition, portfolio insurers sold approximately $900 million in NYSE stocks. In stocks and futures combined, portfolio insurers had contributed over $3.7 billion in selling pressure by early afternoon.

“From 1:10 – 1:20 p.m., program selling constituted 63.4 percent of NYSE volume and over 60 percent in two intervals from 1:30 to 2:00 p.m. In the last hour and a half of trading, insurers sold $660 million in futures. The DJIA sank almost 300 points in the last hour and a quarter of trading.”

Sophisticated investment tools did not make the situation better. They made it worse, but the bank of Alan Greenspan was ready. In this crisis, as in every crisis over the next 18 years, the Fed provided credit when credit was wanted. It encouraged speculators and homeowners to believe that credit would always be forthcoming, only more abundantly than before. After the crash of ‘87, the LTCM collapse, the Russian bonds, the tech bubble, Argentine debt, and the recession of ‘01-’02…after each crisis people let out bigger sigh of relief. There seemed no crisis so big that the Fed could not handle, no risk so great that wasn’t hedged by the maestro himself, and no real danger to the economy or its speculators. The Great Moderation had arrived…this time, a new era for sure.

More news from our team at The Rude Awakening…

————–

Chris Mayer, reporting from somewhere in the Far East:

“Corporate America is flush with cash…Lots of it. This little-noticed fact could create great opportunities for value investors like ourselves.”

————–

Bill Bonner, back to London for various reflections…

*** “Ben Bernanke is going to have a challenge,” said Joseph Stiglitz, a Nobel-prize winning economist at Columbia University in an interview yesterday. “He’s inheriting an economy that has some fragility going forward. The high level of debt, rising interest rates, problems of oil – all of this means he is going to have to manage the economy in a very difficult situation.”

Really. Good thing Bernanke is lily footing his way around the Senate then, huh? Yesterday he promised to “maintain continuity with the policies and policy strategies established during the Greenspan years.” Bravo. Can’t wait.

For our part in the circus, we sent – as we’ve been threatening to do – 537 copies of our new book Empire of Debt to all the Senators. And their cohorts across the rotunda. And the Commander-in-Chief down the street.

The cover letter we sent with the book suggested that continuing the policies of Alan Greenspan, while it might be what the country wants, is not likely to yield the desired result.

*** John Mauldin recently came to London. We were invited to have dinner with he and the GaveKal crew.

It was a troubling dinner. Because they – Charles Gave and his son Louis-Vincent – are very persuasive. Gave is French, and lives right around the corner from us in Paris!

He suggests that a new kind of business model is transforming western economies: the platform company. These companies don’t make anything. They leave the manufacturing to Asia. Instead, they focus on branding, marketing, designing, and retailing, without the capital expenses, nor the high labor costs of manufacturing. They are relatively insulated from economic downturns, and they are very profitable. Don’t worry about trade deficits or consumer debt, he says; this new model will keep the U.S. economy on top of the world for a long, long time.

The platform concept is the least disturbing part of the model. We were ready to go along with it, more or less. It does seem to describe a stage in the evolution of late, decrepit American capitalism…which is a little like the stage of late empires generally where they outsource almost everything …including the fighting.

Still, the description of ‘platform’ companies is mostly accurate in description…even if misleading in prescription.

(More on this below…)

*** A U.S. trade official says he expects the U.S. trade deficit with China to top $200 billion this year.

Meanwhile, foreigners may be getting tired of financing this deficit. Alan Greenspan said so himself: “At some point investors will balk at further financing.”

The Bank of International Settlement keeps track of cross-border capital flows. They note that more and more of them are being made in euros. In the first three months of this year, says BIS, 42.5% of foreign investments were in dollars, 39.3% in euros. The dollar portion was down 4%; the euro percentage was up 5%.

*** The woman dressed as a banana reminded us of other eccentrics we’ve been happy to know. One acquaintance always wore his clothes backward. He had also learned to read and write upside down and back to front. He was a hobo who liked to hitch rides on freight trains.

None of this is particularly commendable. Like most extraordinary achievements, such as stuffing billiard balls in your mouth or learning the logarithmic tables by heart, it is probably not worth doing. Still, in a world dominated by people as grey and monotonous as a Senate hearing, a little lively color is a relief.

Another acquaintance would never say a word that began with the letter ‘F’. We wondered why. It was as if he had missed a day of school as a very young man and never caught on to ‘F’. All his life, he dodged the letter ‘F’. He never sat “on the fence,” for example. Instead, he sat on the enclosure or the wall or the barrier. Nor did he ever “have a little fun.” Instead, he enjoyed himself, or he amused himself. Or he merely had a good time. The poor man couldn’t even count properly. “One, two, three, quatro, cinco, six, ” he would say.

Finally, we asked him why he never said a word that began with ‘F’.

“My mother told me never to use the F-word,” he replied. “I never have.”

“Maybe she didn’t mean all words that began with ‘F’,” we suggested. “Maybe she just had a single F-word in mind.”

“I never thought of that…”

This Time It’s Different 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.

For the first time we see inflation actually showing the results of rising energy costs, and the number is ugly. But it is not as ugly as it could be. Like the making of sausage and laws, looking at how the Consumer Price Index is calculated it is not pretty.

"A 12% jump in energy prices in September caused the CPI to rise by

1.2 % last month, the largest monthly increase since a 1.4% rise in March of 1980. The sharp rise in September followed increases of 0.5% in each of the prior two months, bringing the annual inflation rate for the quarter to 9.4%." (Dean Baker at CEPR)

However, if you look at the core inflation, without food or energy, it was just 0.1%, which is the same as it has been for the last five months. That means that the annual rate in the core inflation rate for the last quarter has been just 1.4%. But as we will show in a few paragraphs, that number doesn’t tell the whole story. If you take out the housing component of the core index, you find that inflation has been rising 2.2% over the last quarter.

But the government changed the way it calculates the housing portion of the CPI back in 1982. If you use the old method, you would find that inflation is 5.3% today and even core inflation is 4.3%. This is a far cry from 2.2%. Can you imagine the 10-year bond prices if inflation was thought to be 5.6%? Somewhere north of 7%, I would think, and certainly high enough to put more than a crimp in housing prices.

Inflation and Housing Costs: Shedding Light on the Confusion

If all of this sounds a bit confusing, that is because it is. Let’s see if we can shed some light on the process.

The government currently assumes that housing costs are 23.158% of the Consumer Price Index. Prior to 1982, the housing cost numbers were based upon what you actually spent for the house and the related mortgage. After 1982, the Bureau of Labor Statistics (BLS) began to use an imputed number. They now use what is known as "owners’ equivalent rent of primary residence" for the housing portion of the CPI. This is based on an economic theory that says that homeowners are essentially leasing the houses from themselves and paying implied rent for that service.

In theory, they are trying to figure out what it would cost you to rent your home. There’s actually a rational reason for doing this and we will talk about that in a minute, but first let’s look at the numbers.

Why are these imputed rents so low? Dean Baker tells us, "The main factor holding down shelter costs is the overbuilding associated with the housing bubble. This has led to record nationwide rental vacancy rates, which is putting downward pressure on rental prices in many of the areas with the biggest bubbles in housing prices. For example, rents in the New York City area rose by just 1.9 percent over the last year. They rose by 1.8 percent in Tampa, Florida and by just 0.3 percent in both Boston and San Francisco. (This is the inflation rate for the owners’ equivalent rent index, which strips out utility prices.)"

How much does using imputed rent affect the CPI? Bill King wrote a few months ago, "In the Q1 GDP data, the US government has housing prices up only 1.1%, yet industry data shows double digit gains. And this week the June existing home sales data shows a 14.7% increase in the median house price. The BLS has ‘owners’ equivalent rent of primary residence’ up only 2.2%.

"A couple of months ago, we delved into the BLS web site and discovered that "owners’ equivalent rent of primary residence" is also suppose to account for real estate tax hikes. The Rockefeller Institute has the average US real estate tax bill +6% y/y. Of course it’s double digits in most urban areas.

"Here’s the math: 14.7% + 6% = 20.7%. But the BLS calculates this at 2.2%. 20.7% minus 2.2% = 18.5%. Now multiple by 23.158% and you get 4.28%. So by this metric, CPI is understated and thus GDP overstated, by 4.28%."

Indlation and Housing Costs: Not Feeling Like a Recession

Remember that real GDP is calculated after inflation. You subtract the inflation rate from nominal GDP to get real GDP, which is the number everyone focuses on. So if inflation is higher than the BLS statistics show, which means GDP is not as high. The numbers have not changed all that much since the first quarter, so that would mean that GDP growth is almost non-existent if we used the old method of figuring housing costs.

If the CPI were 5.3%, we would be in a serious recession. But it doesn’t feel like a recession. Profits are rising, unemployment is falling and things seem to be moving along just fine, thank you. So what gives? Is there some government conspiracy to understate inflation, so that they don’t have to pay large increases in Social Security and other inflation indexed payments? The answer is – not really.

If you look at a graph of home ownership cost you find that the numbers are actually very volatile. And I mean very volatile. In 1985, prices were rising at 6%, and just two years later prices were falling by 6%, but one year later 1988 prices are rising over 8%. Dramatic swings of 4-5% over a period of a year are quite common.

If you look at a graph of owners’ equivalent rent you find that the volatility is much less and the moves take a longer time. Instead of 14 percentage points swings in just one year, you get 1-2%.

If you put these charts together, it almost looks like the imputed rent is an average mean of the actual costs. By that I mean that the actual costs swing both higher and lower, constantly reverting to the mean or long term average. Now that is not what it actually does from a calculation standpoint, but the chart sure looks that way.

In an odd sort of way, the imputed price seems to work rather well in smoothing the volatility. Otherwise we would have times when GDP said "recession" while the economy was growing and vice-versa. And this makes a certain sense.

Economists often claim that the CPI overstates inflation. And the housing component did do just that in the periods around 1987 (by 10% at one point!), from 1989 through 1994, briefly in 1996 and from 2001 through 2003.

But now, we are getting a rather large difference of almost 8% between actual costs and imputed rents! Looking back since 1982, this is the largest such difference of any one period.

Inflation and Housing Costs: Housing Prices Must Stop Growing

What does that tell us? If this is indeed a mean reversion effect, as the chart makes it look to be, then we would expect either rents to rise or housing prices to become stable or fall, and not too far into the near future.

But as noted above, we now have record nationwide rental vacancy rates. Such does not portend for a rise in rents, so we are left with the thought that housing prices must at least stop growing, if not fall somewhat. And we read in paper after paper that they seem to be doing just that.

Could it be that the Fed rate increases are having an effect? Today, if you decided to buy a home and planned to pay it off in a few years, you find that a 15-year loan is cheaper than a one-year ARM. In fact, you would pay 5.625% a year with perfect credit! That is a far cry from the lower than 2% ARM rates of just a few years ago. (I know, Bloomberg says rates are lower than that, but try and get one!)

Gone are the days of the cheap mortgage. In the United States, refinancing a home last year brought in an astonishing $600 billion – or about 5% of GDP. That is, people "made" more money from refinancing their houses than they gained from salary increases, investment returns or any other source.

As housing price gains slow and then maybe stop, as interest rates continue to rise, that "cheap" money from borrowing against your home is going the way of the dodo, at least for awhile.

So, which is it? Is inflation running at a 9.4% clip, a 5.6% rate of just over 2%? The correct answer is both. It just depends upon how you want to calculate the numbers and over what time period you want to calculate them.

But the various Fed governors seem to be calculating them using numbers, which suggest inflation. Bert Dohmen brought this quote from Fed Governor Richard Fisher of Dallas to my attention, "We cannot let the equivalent of sclerosis block the arteries and disrupt the workings" of the economy, Fisher said. "Nor can we let the inflation virus infect the blood supply and poison the system."

As a little side note, using BLS statistics, health care costs are about 17.5% of consumption, but it is weighted much less in the CPI calculation. Healthcare is 4.649% of CPI; healthcare commodities are 1.484% of CPI. Healthcare is reportedly 15 to 17% of GDP. This presents a huge discrepancy in CPI weighting. If CPI healthcare costs were in tune with reality AND they had an accurate weighting, CPI would be substantially greater. (Bill King)

BLS assumes health care costs have risen about 4% a year for the last ten years. Anyone who is paying health insurance knows this is not the case.

Regards,

John Mauldin
for The Daily Reckoning

October 20, 2005

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

In his easy-to-read, straightforward style, Mauldin spots the big market trends – and shows you how to profit from them. Bull’s Eye Investing is a must-read road map if you want to avoid the pitfalls of the modern investing landscape…

The Bird Flu is still advancing from the East.

Hurricane Wilma is coming up from the South.

The real threat, Jeremiah warned the Israelites and the minister of St. Michael’s warned Londoners, is internal, not external.

But here…we give the devil his due. Events have a way of being linked together. One thing leads to another, and to another…where the chain leads, we cannot know. But sometimes it just seems to go bad.

King Edward III’s daughter died of plague in the 14th century. She was not the only one. The disease carried off the king of Castile, the queen of Aragon, the son of the emperor of Byzantium, the queen of France, and the queen of Navarre. Neither purple nor velvet were proof against the malady.

The archbishop of Canterbury died. Then, his successor died, and then his successor’s appointed successor died, too.

In some places, half the population was wiped out, with a third of the entire population from India to Iceland in their graves before the plague disappeared.

Where did the plague come from? It arrived with the great Mongol empire. In the battle for the Genoese port city of Kaffa (now Feodosia), the besieging Mongols had an idea; they would catapult the bodies of their own plague victims over the city walls. It took little time for the fleas on the infected bodies to jump to living bodies…and soon the town was sick. Those still healthy had had enough; they retreated in their galleys across the Black Sea back to their homeland, Genoa, and brought with them the cursed disease.

For many, death from the plague must have come as a blessed relief. Early in the 14th century, Europe suffered some of its worst weather, poorest harvests, and bloodiest uprisings in history. Violent storms hit the coasts and destroyed dikes. Cold, rainy summers ruined harvests. The price of food rose 500%. People ate cats, rats and even animal dung. When those delights ran out, they dug up the dead and ate them.

Those who did not starve to death or die of plague often died from violence. In 1303, the pope himself was captured by a mob. He died soon after under mysterious circumstances. The next pope was murdered. His successor removed the whole papal administration to France, to Avignon, where he thought he might be safe.

But there wasn’t much safety to be found anywhere. Peasant uprisings, the Hundred Years war, the Jacqueries, Guelphs vs. Ghibellines, bands of brigands roamed the country. "What shall they say that readeth this or heareth it read," asked the era’s leading historian, Froissart, "but that it was the work of the Devil?"

The devil works in strange ways: he causeth people to believe what they must believe when they must believe it. Thus is U.S. Treasury Secretary junketing around the world telling the poor benighted Chinese that they should take advantage of Wall Street’s "sophisticated" expertise? We don’t know…but we think he may be lobbing dead bodies over the city walls, trying to infect our rivals with the disease that has so weakened the Anglo-American economies.

Of course, few people on Wall Street or the U.S. Treasury department would agree with us. They claim there is some magic to shuffling money. The sophisticated dealers role up their sleeves, split the deck, mixed up the cards, and whammo bammo…there are twice as many of them! Here in London, we see the evidence of this expertise everywhere. The City, London’s equivalent of Wall Street, is the country’s most profitable industry. On both sides of the Atlantic, the masters of the universe seem to be holding the best cards. Just walk into a fancy restaurant without a reservation, or try crossing the street without looking both ways, and you will find yourself without a meal…or without a leg. Small comfort will be that you have saved yourself $500 or been run down by a Porsche. All this money must come from somewhere. But where? Are they really offering the world a ‘new deal’ based on sophisticated new knowledge that better allocates capital and increases everyone’s wealth? Is it another milestone on the road to progress, democracy and prosperity?

Or is it another devilish old false shuffle – loading up the world with debt while skimming the best cards for themselves?

We will see, dear reader, we will see.

More news from our comrades at The Rude Awakening…

————–

Steve Sjuggerud, reporting from Florida:

"While real estate rises over the long run, there are distinct periods where it falls. In short, based on a Fed study, right now we are right at the point where home prices should turn over and head downward again."

————–

Bill Bonner, back in London with even more views…

*** "The price of gold has really backed off this week, which is fine with me, as it gives the investors in our MarketSafe Gold CD a good entry point," says our pal over at EverBank, Chuck Butler.

"Keeping its head above that $470 level has been difficult for gold, but from my view in the cheap seats, it looks like it’s just biding its time, forming a strong base, before heading to $500."

*** Elizabeth was out last night, so we took the boys to Burger King for dinner.

"Mmmm…this is great," said Edward.

"Yeah," said Henry, "how come we never eat here?"

"Well, your mother doesn’t like it," was our weak reply.

"Why doesn’t she like it? We like it."

A pound is a dollar is a peso. The meal cost only about 10 pounds for the three of us, or nearly twice as much as the same meal in the United States, or six times as much as the same meal in Argentina.

On the other hand, the meal we had, with friends, the night before – in a fancy restaurant in South Kensington – cost 20 times as much. Was the previous night’s meal any tastier, we asked ourselves? No, not really. Was it more satisfying? No, not really. Was it more nutritious? We don’t know, probably not. No, it was none of those things. Instead, it was different; it was more sophisticated.

The conclusion we draw from this is that sophistication is merely a way of separating people from their money. Not that they aren’t grateful for it. A sophisticated car is one that costs more money and breaks down more often. A sophisticated wine is wine so expensive that you don’t want to open it; when you finally do pull the plug, you find that it has gone bad. A sophisticated art lover is one whose walls are covered with hideous mock-art. And a sophisticated reader is one who picks up dull books that have won literary prizes and pretends they are good. A sophisticated homeowner is one who has mortgaged 100% of a house he cannot really afford. In each case, the sophisticated player feels superior…he is, after all, more sophisticated! But what about a sophisticated investor?

We recall that Warren Buffett, the most successful investor who ever lived, is noticeably un-sophisticated. He does his calculations on a yellow pad, with a pencil. He operates on the basis of old fashioned, well-known principles. He does not use sophisticated strategies or sophisticated techniques. He merely buys good businesses, run by people he trusts, at prices he thinks reasonable.

Buffett is the second richest man in the world. Think how rich he would be if he used Wall Street’s sophisticated expertise! Won’t some enterprising stockbroker, maybe from Vancouver, give the poor man a call?

Inflating the Numbers 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.

I’ve recently made the case that the Fed needs to pause in its "measured tightening" cycle, for at least the September Fed meeting, until we can see the full effects of Katrina and the oil shock upon the U.S. economy. We will really not know all that much by September 20th, and given the Fed emphasis upon approaching central bank policy as a task of risk management, that seems the prudent thing to do.

Pausing for 40 days, until the November meeting, though, would not suddenly send the economy into a dangerous spasm of inflation. If the economy adjusts, and oil refineries and shipping come back online in good order by then, as it most likely will, then they can continue their tightening cycle with no danger to the economy. But if we do find problems, the downside risk seems, to me, to be too great.

It is not yet altogether clear that Mississippi’s shipping will be back up in time for the fall harvest. Any other shocks (we are still in the middle of hurricane season) at this delicate time could be of real concern. Patience, at least for 40 days and 40 nights, is called for. Even God took that long to get things back to normal when things needed cleaning up.

Post Katrina, we have had three Fed governors speak. Frankly, they still seemed to be tied to the party line of the potential for a return of inflation. I found no quicker or more on-target assessment than that which comes from Dennis:

Measured Tightening: Is the Previous Course the Proper Course?

"We think, therefore, the odds are greater that the Fed shall pause and do nothing at the upcoming meeting. We think that is what reasonable people would do under the circumstance. We think that is the right thing to do. But are we certain that is what the Fed will do? On that we are wholly uncertain.

"…Having stated our preference, we must admit that the ‘hawks’ have been rather overtly public in putting forth their position that Katrina is exogenous and that their previous course of action remains the proper course. We noted, of course, the very hawkish Gartman [by "hawkish" Dennis means aggressive in controlling inflation, and in this instance by raising rates] comments made earlier this week by Mr. Moskow of the Fed Chicago. Now we note the comment made recently by Mr. Santomero, the President of the ‘Philly’ Fed, who said, ‘As the expansion matures, the price dynamics at work in the economy will shift [upward].’ Mr. Santomero was concerned about inflationary forces at work.

"We understand that concern, and there is no question but that Katrina will exacerbate those concerns as the re-building process begins over the course of the next several months and shall continue for several years into the future. But, does that mean that the Fed cannot choose to pause, if only for a while? We think not, but Mr. Santomero may think otherwise… and let us be rather honest: his opinion counts a bit more than does ours.

"What really caught us off guard, however, were the comments from Ms. Yellen, now the President of the Federal Reserve Bank of San Francisco, and a former Board member of the Federal Reserve. Ms. Yellen, we would hope, is fully cognizant of the Fed’s ‘political’ situation and so we suspect that her comments are weighed, and weighed again before they are made. Thus, we tend to listen to Ms. Yellen quite closely, and she has spoken rather overtly ‘hawkishly’ in the past day or two. Noting that the effect of Katrina will indeed slow GDP growth in the fourth quarter of this year, Ms. Yellen nonetheless said that the effect of rising oil prices may more easily be passed through to the consumer than they have been passed in recent years. Her tone was one of very real concern, rather than of merely being modestly bothered by that possibility.

"So now we have Moskow, Santomero and Yellen staking out the ‘Hawk’s’ position and doing so rather publicly. We are hoping to hear from the ‘Doves.’ We await someone to take up that position and to do so as publicly as Moskow, Santomero, Yellen & Co. have staked out theirs. The problem is that in the company of central bankers, the ‘dove’ is always the outcast bird."

Measured Tightening: Should the Fed Act Pre-emptively?

It is easy to see inflation as a potential problem. The serious rise in housing prices, and Fed concern about them, is well documented. The Fed is getting ready to pump massive amounts of money into the economy. Coffee is up seven percent and sugar up 30 percent due to delivery and shipping problems. The materials needed to rebuild, like copper, aluminum, and timber will be in large demand. As oil rises, shipping prices for products are going to rise. If Yellen is right, and price increases imposed by increased costs "stick," one can readily argue that we could see a surge in inflation. And with inflation near the top level of what the Fed is comfortable with, shouldn’t the Fed act preemptively to make sure inflation does not come back?

The short answer is no. There are forces, which combined with Katrina, could change those trends. Let’s look at some of them.

Let’s turn to those smart guys at Cumberland Advisors for an analysis of how much pressure the consumer is under. They think the Fed might come to a full stop, as they are concerned the economy will roll into a recession if the Fed continues on its current path. I have noted in past letters that increased energy prices are going to take a toll on consumer spending, but it is not just energy. Increased interest rate costs on mortgages, the new Alternative Minimum Tax and Katrina all make this worse; they put a pencil to the problem to give us an estimate of the cost and the potential hit to consumer spending.

"Energy is the largest of a four-pronged attack upon the economy. We will compare the size of these four prongs with Disposable Personal Income (DPI) to demonstrate the magnitude of the problem and why they may lead to a consumer-led slowdown.

"Quickly, DPI is about nine trillion dollars according to the latest Bureau of Economic Analysis (BEA) estimate. It is what the 295 million of us have left to spend after taxes and some other minor adjustments. It is the source of our consumption spending and our debt payments. Fortunately, BEA data break out the energy costs we incur."

Measured Tightening: A Look at Housing Prices

Let’s hold that thought while we look at housing prices. This point comes from Martin Barnes at Bank Credit Analyst:

"The current 11% year-on-year gain in real house prices compares to a 50 year average of only two percent. The current growth is three standard deviations above its mean, and historically, this has broadly been a mean reverting series. The odds are high that the growth in real house prices will fall below zero in the next few years.

"The low level of long-term interest rates will provide a cushion for housing, but will not be able to prevent the market from cooling. The main drag on housing may come from the reduced supply of mortgages rather than a more typical interest-rate induced drop in demand. However, regulators are likely to clamp down on the more speculative types of loans and this will constrain housing demand. Moreover, as we have noted in the past, the experience of the U.K. and Australia suggests that even a leveling off in prices will be sufficient to cause a marked retrenchment in consumer spending growth."

Recent data suggests that the housing prices may be under some pressure. There is a very close correlation between housing prices, consumer confidence, and consumer spending. Any decrease in consumer spending will be in addition to the decrease noted above by Cumberland. All of this suggests that it is time to be cautious. Even if the Fed were to raise rates, they are close to the end of the cycle. Rates are close to where they should be even if you are very hawkish on inflation. There is no need to hurry the process, and every reason to wait. In the past, the Fed has tended to go too long and too far in their rate hike cycle. No need to repeat that mistake.

In a call with Martin Barnes today, he made it clear that he believes the Fed will pause. Martin is as astute an observer of the Fed as any person I know. When asked about the recent Fed speeches, he says simply that they are continuing with old Fed policy and that things will change when Greenspan decides they will at the next meeting. It is Greenspan’s decision that counts. Finally, Martin was forecasting a slowdown prior to Katrina, but he does not think we will fall into recession. He sees it as more like a mid-cycle slowdown similar to what we saw in the mid 1990’s.

There are more and more calls for the Fed to pause in September. Clearly the markets are expecting them to do so, and this has given a boost to the stock market. There is the perfect excuse and a very easy-to-write reason: They could simply say they wait for more clarity, but barring some new data suggesting a softening of the economy, they will continue on their rate-hike path.

Yet, there is less, rather than more clarity as to what they will do. This meeting, barring a comment by Greenspan, is shaping up to be the most interesting in a long time; as everyone has known for the last ten rate hikes, that it would be at a measured pace of 25 basis points per meeting. At least for this meeting, there is uncertainty.

Regards,

John Mauldin
for The Daily Reckoning

September 15, 2005

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

In his easy-to-read, straightforward style, Mauldin spots the big market trends – and shows you how to profit from them. Bull’s Eye Investing is a must-read road map if you want to avoid the pitfalls of the modern investing landscape…

More of the world according to The Daily Reckoning…

The trouble with trouble is that Americans can’t afford it. They have spent all their money on granite countertops. When a rainy day comes, they have nothing saved up for it. The flood on the Mississippi delta, for example, was quickly followed by an emergency-spending package of more than $50 billion.

Whether the spending will help anyone or not, we don’t know. But the loot has to end up in someone’s pockets. We don’t know where the money will end up either; but we know where it won’t come from. It won’t come from American savings because they barely exist.

In today’s paper we find that another delta has gone under: Delta Airlines. The poor fliers carry $18 billion in debt. As oil prices rose, they had no reserves, no cushion, no savings in which to turn. Yesterday, the burden became too great; they went to court to ask the government to help get creditors off their backs.

What a way to run an airline!

But we cannot single out Delta for mockery. Three out of seven of America’s top airlines are now bankrupt. A fourth, Northwest, is said to be considering it.

It makes us wonder. Rising fuel costs have been widely predicted, including here at The Daily Reckoning. We can understand that airline executives wish to cut costs, but The Daily Reckoning is free. What’s more, higher energy prices were not only an obvious risk, but practically inevitable. Every single day, beginning with the first barrel of oil ever pumped in Titusville, Pennsylvania, the world’s ultimate quantity of oil has gone down. Oil engineers also noticed that even though extraction technologies grew more sophisticated, they were not able to keep up with the pace of global consumption. By the 1970s, America’s oil output was already in decline. Production for the entire world should go into decline this year or the next.

It is true, too, that alternative energy sources are being discovered and exploited. But there were no plans that we know of to retrofit Delta’s fleet of jumbo jets to run on batteries or solar panels. They were designed to run on petroleum products – a lot of petroleum products. Our friend Byron King has estimated that a single regularly scheduled transatlantic passenger plane consumes more energy than was used up in the first 100 years of in the exploration and settlement of North and South America. (We can’t recall his calculation, but it is something like that.) Which means that the airline industry must be particularly and obsessively sensitive to fuel prices.

Oil prices have gone up; but in real terms, oil is still not as expensive as it was during the oil shock of the 1970s. Since then, the planet used up more oil than it had in any three prior decades in history. Anyone could look back and see the heights to which oil could go. And anyone could guess about the effect of the last 30 years of usage: The real price of crude might well be higher than it was in the ’70s, not lower.

Which makes us wonder: What did airline industry executives talk about when they got together? The weather? Golf? Kant’s concept of the categorical imperative? How could they run a business so acutely sensitive to energy without making any provisions for higher prices? Did it never come up in conversation?

Delta executive number one: "Uh…what are we going to do if oil prices rise?"

Delta executive number two: "Don’t worry about it. All airlines will be in the same fix. We’ll all just have to raise our prices. And renegotiate our union contracts. "

Delta executive number three: "Are you kidding? As competitive as this business is? We’ll all go out and borrow money so we can use the crisis to gain market share. If we raise prices we’ll lose market share."

Delta executive number four: "But what good will it do to get more market share if we have to operate at a loss? Won’t we be losing money on each sale and trying to make it up on volume?"

Delta executive number five: "Oh, stop worrying. We’re the most dynamic industry in the world’s most dynamic and flexible economy. We’ll think of something."

More from our friends at The Rude Awakening:

————–

Chris Mayer, reporting from Gaithersburg, Maryland :

"It’s frightening…It’s difficult…It’s harrowing…and it’s very, very profitable. I’m talking about ‘distressed investing,’ also known as ‘vulture investing.’ It is the ultimate expression of contrarian investing…"

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening:

————–

Bill Bonner, back in London:

*** Delta Airlines was founded in 1924. It operated through several wars, a stock market crash, the Great Depression, countless industry bankruptcies, inflation, deflation, recession, boom, and bubble. And yet, there it sat, like the other delta at the mouth of the Mississippi, blankly waiting for a storm that anyone could see coming just by looking out the window. When trouble came, neither delta could afford it.

But that is the way the world works, dear reader. People do not make logical, rational and sensible choices. They get caught up in things that have a logic of their own. All over America there are millions and millions of Delta households, Delta businesses, and Delta governments – state, local and federal. All add debt and increase expenses – knowing full well that interest rates could rise, incomes could fall, house prices could drop, and lenders could balk at extending further credit. Any or all of those things are as obvious, imminent and inevitable as an increase in oil prices. When they come, Deltas will go underwater.

*** "If America becomes so unglued when bad things happen in its own backyard," Thomas L. Friedman quotes a hack colleague from Singapore, "how can it fulfill its role as leader of the world?"

Of course, the Romans had plenty of trouble in the homeland, too. Fires burned down much of Rome itself. There were periodic insurrections, slave rebellions, fights for imperial succession, murders, incompetence, unbelievable depravity, corruption, vice, and civil wars. The city of Pompei was completely destroyed by the eruption of Mt. Vesuvius. But that didn’t stop the Romans. They carried on their campaigns of military subjugation for hundreds of years, despite troubles at home.

Don’t worry, dear reader, the New Orleans inundation will not prevent America from playing its role or fulfilling its historical mission. The show must go on!

*** Edward’s Frenglish is getting worse. In Paris, he spoke French at school and English at home. Now that he is with other bilingual children, he seems to mix the two languages more and more.

A sample sentence: "My teacher told me that if I didn’t do tout mon devoir en classe, I would have to do more travail a la maison."

We are beginning to wonder about bilingual education. Instead of making him competent in both languages, so far it seems to be making him incapable of speaking either one correctly.

To Pause, or Not to Pause? 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.

Looking at a recent magazine covers one is left with the impression that the whole world is concerned about U.S. real estate prices. This is borne out by the fact that if you go to Google and type in sex you get 78,000,000 hits. If you type in real estate you get 110,000,000 hits, which makes housing about 40% more interesting than sex. Is there a greater sign of a bubble? But if you type in housing bubble you get "only" 1,120,000, so there is not much worrying going on

In doing my research, I rounded up an amazing list of facts and figures. Let’s first start with good friend Gary Shilling, who always manages to come up with an assortment of data and charts. This is from his July 2005 letter, which came in just in time for this week’s letter on housing.

No surprise, Gary is worried about there being a bubble and the possibility it could damage his prediction of a rather benign, if not in fact good, deflation. He starts out:

"The housing bubble is not local, but national-not surprising since it’s driven by economy-wide forces: investor zeal for high returns but skepticism over stocks, ample cheap mortgage money, and lax lending standards. Indeed, these forces and the housing boom are global. Earlier U.S. housing booms-busts were driven by local business cycles such as the rise and fall of the oil patch along with oil prices in the 1970s and 1980s. Since houses are much more widely owned than stocks, the bubble’s likely demise will shake the economy more than the early 2000s bear market. It could change the good deflation of excess supply we foresee to the bad deflation of deficient demand. The most likely bubble-pricking pin is massive speculation itself, and as prospective buyers stand aside, mounting inventories will precipitate a downward price spiral."

"…The national scope of the housing bubble is no surprise given its driving forces. They aren’t local economic booms. Indeed, there’s nothing anywhere in the country today to rival the oil patch boom in the 1970s, the Cold War aerospace spending jump in the late 1980s or the dot com bubble of the late 1990s. Instead, the driving forces, discussed earlier, are national – the appeal of real estate as an alternative to stocks and low interest rates. And lax lending standards. The leap in subprime loans from 9% of total mortgage originations in 2003 to 20% last year, according to the FDIC, is telling. So are the high loan-to-value, interest-only and option ARMs mortgages mentioned earlier."

The Housing Bubble: That’s Why It’s Called "Irrational Exuberance"

The National Association of Realtors estimates that 23 percent of U.S. homes purchased last year were for investment. Another 13 percent were second homes. About 23 percent of homebuyers nationwide are using interest-only loans, according to Loan Performance, a company that tracks loan originations. Interest-only and other types of adjustable-rate mortgage loans allow borrowers to pay no principal and sometimes little interest for an extended time while gambling that home prices will keep rising.

But investors are nothing if not optimistic. The LA Times, in a recent survey, reports that local homeowners expect to see housing prices rise by 22% annually for the next ten years. Now this is a group, while admirably optimistic, that clearly didn’t pay attention in math class. Compounding at 22% a year for ten years is an 800% appreciation, doubling every 3.27 years. 22% doesn’t sound like much. Let’s just project today into the long-term future. Not doing the math, they do not realize that means homes would have to go up in value 8 times! But such is the nature of bubbles. That is why it is called "irrational exuberance."

A UBS/Gallup poll shows that only 13% foresee a decline in housing prices over the next 6 months. 67% of investors see real estate investments as more profitable, and 77% see such investments as safer than the stock market.

There are clearly bubbles in some areas of the country. That being said, the average home is still affordable by the average person, according to the housing affordability index. But not in the bubble areas. Only 17% of the U.S. can qualify for a mortgage on a median priced home in California. In certain areas it is much worse. This is not surprising for certain wealthy enclaves, but this is for an entire state!

But if much of the growth in housing values has been in a few select areas, and data suggests that is the case, then it also means that much of the ability of homeowners to use their homes for refinancing is also in those areas. So much of the U.S. economic growth that was created by the asset bubble in housing is coming from a small (yet significant) number of areas in the country. Various estimates are that this adds as much as 2% to overall GDP. Further, economists at the Fed estimate that the economy would slow by 0.2% for every 1% drop in housing values. A softening in housing values in those bubble areas would significantly affect the whole country in a negative way just as their growth influenced a positive growth.

The Housing Bubble: Homes Bought for Investment

Last year, we built 2 million new homes. Yet we added only 1.2 million new households. That means we absorbed about 800,000 homes either as second homes or for investments. Given various studies, it is probable that around 500,000 homes were bought for investment over and above the number of new households.

That is a major part of the bubble. If new homes were rising in line with the growth in households, there would not be the potential for supply to outstrip demand. When, not if, we enter a recession with a significant overlap of excess supply while unemployment is rising, that could cause a sharp break in housing values in certain areas.

We live in a cash flow society. We look at our income and then judge how much we can afford to spend. Rents are actually falling while prices rise. When home prices fail to rise every year, when investor confidence breaks, households will look at their cash flow and realize that they might be better off renting.

But that may not be for some time. I remember writing about how the NASDAQ was overpriced in the 4th quarter of 1998. I watched the stock market take wings after that. Bubbles which are caused by investor expectations and irrational exuberance can last a long time.

This is especially true if interest rates stay low. It goes double if mortgage rates drop from here.

Let me outline a very plausible scenario, and one which will illustrate why the Fed is in such a bind. If the Fed stops raising rates at 3.5% (meaning one more 25 basis point increase in August), what impetus will there be for long rates to rise?

The economy is still growing nicely, up a revised 3.8% in the first quarter. The ISM number rebounded today. Unemployment is down. Inflation ex-energy is benign, and soon we will be at a place where the oil prices from a year ago will not reflect the significant rise that they do now. It is highly likely that we print a lower inflation number in the last half of this year than we did in the first. And with all the good news, long-term rates are still low.

The world is awash in capital, and it seems to want to find a home in U.S. fixed income instruments. The U.S. government deficit is dropping, which means we are making less new government paper for foreign central banks to buy, yet they (and foreign private citizens) are buying more of our debt, putting more downward pressure on interest rates.

Low inflation, excess world savings coming to the U.S. (for whatever reason) and a flat Fed policy is a prescription for lower long-term rates. This means the environment for housing prices could be quite good for some time to come.

But let’s say the Fed is worried about the housing bubble and wants to slow it down, as well as create a more classically normalized interest rate scheme. So they signal they will continue to raise rates. The market fears the Fed will continue until they cause a recession (as they historically have) and in anticipation they begin to buy long bonds, dropping long rates.

Either way, I think the chance of significantly rising long-term rates, which would kill the housing market is less than 20% in today’s environment. By that I mean I do not think the ten-year will rise to over 5.5%, which is what is needed to really slow the housing market, if that is your objective. (This could all change of course if say China and the rest of Asia were to start doing something else with their dollars, but that is not a likely short-term scenario.)

Bill Gross and others speculate about a 3% ten-year note, which would roughly mean a 4% 30-year mortgage. Can you imagine the wave of re-financing? Every mortgage in America would be re-financed. I think that could easily happen in the next recession. It would certainly soften the usual recession cycle again; postponing the ultimate day we hit the debt re-set button. It would trigger what Roach calls another round of Bad Growth (growth based on debt).

The Housing Bubble: Two Recessions

That is just another reason why I think it will probably take two recessions (and thus a long time) to get to the ultimate bottom of the stock market (in terms of valuation) and to hit the re-set button on debt. It is also why I think the Muddle Through Economy will be the paradigm for the rest of this decade, at the least.

And this worries me. Because the above scenario is a prescription for deflation. Staving off deflation, which is evidently part of the programmed DNA transfer that is required when you become a member of the Fed, will not be as easy the next time as it was last time. Ben Bernanke, who is the man I think will be the next Fed chairman, will have his job cut out for him. I fully believe him when he says that the Fed would "move out the yield curve" in a fight against deflation. He will help the market bring down mortgage rates to help stimulate the economy. Simply lowering short term rates may not be enough.

But what would you have them do? Sit to the side and do nothing as the U.S. slides into a steep deflationary recession? You can argue that there should not be a Fed, but that is not reality. There is and they will act to fight deflation. The die was cast when they decided to use housing asset inflation to offset the bursting of the stock market asset inflation bubble. The fact that it became a bubble was not helpful.

In hindsight, Stephen Roach is probably right. They should have raised rates faster and kept a lid on the housing bubble developing in certain parts of the country. But that is water under the bridge. Now, their choices are fewer, and their weapons are less. Get ready to get the lowest mortgage rate of your lifetime in a few years. But it will not be a sign of a healthy economy. While 4% will be good for us as individuals, we will not like the overall economy and the stock market. Can we hear it for Muddle Through?

Regards,

John Mauldin
for The Daily Reckoning

July 06, 2005

What will happen when interest rates go up, and the subprime homebuyers that are flooding the market right now can’t pay their mortgages? This we can tell you for sure: It will not be good, for the U.S. economy, or the individual investor.

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

We have been fascinated by the big, big picture.

You’ll recall, dear reader, that we resisted the idea of "empire" for a long time. We denied it. We dragged our feet. We insulted the neocons every opportunity we got. We insisted that America should stick with its old ideals…and mind its own business. Not that the old tattered republic was a perfect country by any means. It was full of bosh and claptrap, but we had gotten used to it. Like watching a favorite old comedy, we knew the punchlines and pratfalls by heart; still we always got a laugh.

But the neoconservatives said we were fools. America was an empire whether we liked it or not. No one chose to turn America into an empire; the role was thrust upon us. We had the last imperial ideology still standing, they said. It was time to stop whining and shoulder our imperial obligations.

Getting to like empire, we found, was a little like eating something new and nasty in a Chinese restaurant. After we got over our initial nausea and revulsion, we found we liked the taste of it. We got used to it. We found it helpful in understanding what was really going on. We found that the neoconservatives were right: looking at the United States as an empire explains a lot.

But the harder we looked, the more we saw that the neocons were even bigger imbeciles than we realized. They have noticed that America really is playing an imperial role. They have encouraged it and expanded it. What they haven’t bothered to notice – because they are too busy gazing at their own glorious reflections – is that it is a mad empire of debt and delusion, one that ruins the imperial race rather than enriches it.

That is what makes history so entertaining. As we mentioned yesterday, people seem to come to believe just what they need to believe – just when they need to believe it, in order to make public spectacles of themselves. That is, they need to believe six impossible things before breakfast so that can do something absurd before lunch. It is the aberrations – the exaggerations, the mass movements way beyond the ordinary mean, the empires, the bubbles – that give us some place from which we can regress. And it is the delusions, vanities, and preposterous flatteries that make it all so amusing.

According to a report in Britain’s Guardian newspaper, Americans now spend $1.08 for every $1 they earn. But American economists, politicians, and media manage to spin the numbers so they seem almost normal – if not favorable. Americans spend more than they earn, say the latest hallucinators, so that people in Asia can continue saving so much money. Get it, dear reader? America’s current account deficit is not America’s fault; it’s the fault of all those Asians who haven’t the wit to spend their own money.

That is the sense of the delusion known as the "glut theory of savings," according to which, America does the world a favor by being willing and able to recycle excess savings from Asia. We have to spend the money for them! Thus, we do the whole world a service…helping to match up savings with borrowings…spendings with makings…and takings with gettings. We do not doubt the math of it; for every debit, we are sure there is a credit somewhere (most likely in Asia). We just don’t see how the imperial arithmetic favors the imperial race. That, of course, if the funny part of America’s empire…a little joke on the neoconservatives themselves, with a punch line that is likely to knock the whole nation on its derriere.

More news, from our team at The Rude Awakening:

————–

Dan Ferris, reporting from Oregon…

"You don’t drop the pounds with magical pills and fads. Classical music will never appeal to the impatient. As for investing…well you already know the secrets there, don’t you?"

————–

Bill Bonner, with more views :

*** Gold dropped below our most recent buying target — $425. Buy.

*** Dan Denning’s new book, The Bull Hunter, has hit number 13 on the New York Time’s best-seller list…

This is, of course, great news for Mr. Denning – but it’s not enough to save him from the infamous "green sarong." He hasn’t yet edged Thomas Friedman off of the Amazon best-seller list, so come August 10; you may see a six-foot man wandering the streets of Vancouver during The Agora Wealth Symposium…

*** "I am just a humble American writer with a weakness for old French ‘pierres,’" we explained to the farmers.

The little speech seemed to need a little joke. The farmers looked at each other. Finally, one of the Pierres got it.

The luncheon was organized by one Pierre in order to introduce another Pierre. The two Pierres are going into business with your editor, raising limousine cattle in on his farm in Normandy. But what the farmers wanted to know was what your editor was doing there. That was where the other "pierre" came in. In addition to the Christian name, Peter in English, the word "pierre" means "rock." Christ told the same little double entendre in the French-language version of the gospels, when he said: "On this Pierre I will build my church." St. Peter did as he was told.

Your editor can’t seem to pass a pile of them without wanting to own it; thus had he become the owner of a vast ruin of stone, stale and wood-munching fungus in the Norman countryside. And thus had he become an expert on French fix-up projects.

MoneyWeek magazine asked us for our views on French chateaux yesterday. We have lived among the frogs for more than a decade. We have learned their ways and the ways of their dwellings.

We recalled when we bought our first chateau during the early years of the Clinton administration. "It never rains in the summertime," said one of the Pierres. "And, no, the roof doesn’t leak." One day in July, we found that he lied twice. But this was the just the beginning of the adventure. Nothing is ever quite as straight in France as we Anglo-Saxons imagine – neither the people, nor the laws, nor the chateaux walls. There is always a little "play" in them.

We began our chateaux counseling by explaining our search for our first chateau. We looked at a dozen of them, many of which were owned by English people. They mostly suffered from the same problem – the owners had begun something but were unable to follow through. A few rooms were done up. Others were left undone. Roofs still leaked. Heating systems creaked. Plaster cracked. And finally, the owners packed up and left, often in different directions.

"When I arrived here," said one older Englishman who had not cut and run, "the chateau was broken down. But I was in good shape, financially as well as physically. Now, the chateau is in good shape…and it is I who is broken down. You can make these things work. But it will cost you."

Chateaux are relatively cheap to buy, but expensive to repair and run. Our experience suggests that buyers should expect to spend twice as much on repairs as they did on the purchase. Compared to English prices, however, they will still get a lot for their money. A place already done up will sell for only a third to one-half as much as a roughly-equivalent place in England.

A buyer must also consider the non-financial costs. Doing up a chateau is a consuming occupation. It breaks down not only pocketbooks, but also nerves and marriages. There are all the Pierres to deal with. And the language. And the government. And the community. And the travel back and forth. And the sense of alienation. Taken together, it breaks down buyers.

Irrational Exuberance 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.