Government-Guaranteed Depression?

The American people voted for change, and within months, we’ll have a better idea of what kind of change we can expect. Dan Amoss explores what President-Elect Obama has in store…

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

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

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

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

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

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

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

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

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

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

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

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

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

Regards,

Dan Amoss
for The Daily Reckoning
November 11, 2008

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

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

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

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

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

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

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

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

But there’s always more to the story.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Ai yi yi…

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

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

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

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

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

Until tomorrow,

Bill Bonner
The Daily Reckoning