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With the dollar weak these past several years, and with real estate possessing a tendency to move like other dollar-denominated commodities, most people who rode the recent real-estate boom found it easy to refinance their homes given their commodity-like strength. Rates were falling at the same time, which made the process much easier than normal, especially true with “teaser rates” available as a competitive device for the initial term of the mortgages. At the point they were due to rise, the property owner simply refinanced the home thanks to rising real estate prices. Unfortunately, as the dollar continued to fall, various credit instruments tied to property became less marketable. For example, Citicorp suddenly found it could not find a bid or even place a value on a large portion of its portfolio.

We are now at the point where something should be done about this (a timeless statement), and the Fed would have an easy job, were it able to see it. With a falling dollar the problem, Chairman Bernanke could authorize a simple buyback plan for a portion of the Fed's outstanding Federal Reserve notes. Corporations do this all the time, and institutional investors cheer when companies repurchase their own stock.

The Fed and many “modern” economic commentators no longer realize that propping up their money will solve “the dollar problem” of inflation. They are preoccupied with running the economy through interest rate targeting: high means stop, low means go. At least, I think that is the translation. Simply put, rather than seek to maintain a stable dollar, the Fed guesses on a proper rate target in hopes of achieving stable, non-inflationary economic growth.

A better, more time-tested answer would be for the Fed to support the dollar at some predetermined level, which used to be the gold price chosen by Congress. This is admittedly tricky today absent an old-fashioned reference point, but it is essential for the monetary authorities to realize they must buy their own currency when they believe it has sold below the correct number, or, in other words, when it has weakened too much.

Think about it: if the Fed, the monopoly supplier and therefore ultimate dollar insider, isn’t going to buy dollars when they are cheap, who will?

I mention this because last week Mike Huckabee won the Iowa caucus partly on a movement incubated in large part on radio talk shows: the FairTax. If words were deeds, then life would be great. We could simply declare that by switching from a federal income tax to a national retail sales tax, tax cheating would end, code complexity would be a thing of the past, and illegal immigrants would start paying taxes. And, of course, we'd switch into high economic growth -- forever.

The problem is that none of this would happen. People would simply switch from cheating on income taxes to cheating on sales taxes.

Small vendors often fail to withhold sales taxes. Buyers cheat on sales taxes now. They often fail to pay taxes on interstate catalogue sales. They buy some goods in black markets.

This doesn't happen much because sales taxes are much lower than income taxes, but if that were reversed, consumers would cheat more. Look at cigarettes. Organized crime sells smokes on the black market in jurisdictions that impose high cigarette taxes.

There is a large category of economic activity designed to avoid sales taxes -- it's called smuggling. We don't hear that word much anymore, because we're not a sales-tax or tariff-based system anymore. Increase sales taxes to a combined state and federal 30%, up from a state-based 6% now, and watch the dodging begin.

The immigrant stuff is nonsense on stilts. Let me ask you this: If they're here illegally, why won't they also buy and sell goods on the black market?

Then there's the complexity argument. You don't think the lobbyists and lawyers will get involved in this, looking for exemptions on houses, medical services and education? You're going to put a 30% tax on my home purchase, and my doctor visits and my kids' tuition? Yeah, great idea.

And what about business transactions? If you tax business-to-business transactions, then you'll set off a wave of corporate consolidation. Instead of buying from a supplier at a 30% markup, I'll just buy my supplier and be tax free. And what about financial firms like Goldman Sachs, which spend most of their money on payroll and investments, and very little on goods and services? Goldman will pay taxes on what? Paper clips?

If, on the other hand, we institute the most widely supported version of the national sales tax, then business transactions are to be exempted. In addition to the colossal job of selling America on a zero tax rate for business, a rigorous definition of the term "business transaction" would have to be provided. What is a business transaction, exactly? I write articles for publication. I consider it a hobby. Sometimes I get paid. Should I pay sales taxes on money I earn for writing this article?

What about the Internet connection I used to send it? Should readers pay taxes on the connection they use to read my article? What if a reader uses it for his job? If he is a financial adviser, then no, but otherwise it's yes? Will I pay taxes on gas I used to drive to the studio to talk about this article? What if I stop to buy my son Jack a birthday present on the way home?
I'm a recovering tax accountant (and not a good one at that) and I've got 50 ways to avoid this tax swimming around in my head. What about the really smart guys?

And what about transition rules? There are millions of transactions that are, at any given moment, occurring over an extended time. The most obvious example is retirement. I defer taxes now, for retirement later. So I make a decision based on an income-tax regime that doesn't make any sense in a sales-tax regime. Do I get my money back? What about Roth IRAs? I pay income taxes on the money now, and then pay again later when I spend it during retirement? Double taxation isn't really a "fair" tax, is it?

These are the easy-to-see cases, but what about the incredible variety of tax questions raised by installment sales? Inventory accounting? Wholesale purchases? Ebay?

None of this matters anyway. We will never make this change. The 16th Amendment will not be repealed in favor of a tax vigorously opposed by an army of restaurants, pubs and retail stores. It's hard to get good ideas through the ratification process; imagine how hard it would be to push this stinker. In point of fact, the FairTax serves one main purpose right now: It gives Mr. Huckabee the chance to sum up his economic plan in one line. And that just doesn't seem, well, fair.
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Mr. Bowyer is chief economist of BenchMark Financial Network and a CNBC contributor.

Most economists who view gold as a forward-looking inflation signal are calling on the Fed to keep rates higher than the markets desire today, or, would like the Fed to raise them under the supposition that rate increases equal monetary tightness. But this thinking ignores how interest-rate targeting works.

The real purpose of funds rate policy is for the Fed to change the level of interest rates in order to affect spending and economic output, and thus inflation. In Fed-speak, this is called the monetary policy "transmission mechanism” by which the Fed seeks to control the economy and inflation. The institutional theory of demand-siders at the Fed posits that slowing growth translates into lower prices (disinflation), while accelerating growth leads to inflation. Supply-side thinking rejects this theory and believes accelerating growth is actually disinflationary and vice-versa.

But the more important point is that fed funds rate policy is designed to control economic growth, NOT a method for controlling the rate of money supply growth or stabilizing the gold price. It is therefore a popular and unfortunate misconception that higher interest rates translate into tighter money.

In other words, advocates of higher interest rates today are in essence supporting a policy that aims to weaken economic growth even further; growth that is already sagging as evidenced by last Friday's unemployment report. Sadly, actions taken to reduce economic growth will ultimately do little to reduce true inflation, nor will they restrain forward-looking inflation indicators.

The Fed experienced a comparable dilemma to today's during the late 1970's; albeit to a more extreme degree. At the time, the Fed similarly manipulated short-term interest rates with little success in preventing a painful stagflation. Failed rate-targeting efforts eventually forced Fed Chairman Volcker to abandon interest rate targets in favor of monetary aggregate targets in October of 1979.

The policy change was an explicit acknowledgment by the Fed of the failures inherent in targeting the cost of credit to control growth and inflation; especially when growth is slowing and inflation is rising. Volcker was surely courageous in reversing what was a failed policy, but his policy alternative was not perfect because it singularly attempted to directly control the expansion of the money supply to fight inflation. We must remember that monetary inflation is always the condition of too much money relative to money demand. Monetarist targets then and now concentrate solely on money supply without factoring in demand for same.

Fortunately, by 1981, President Reagan’s combination of strong defense policies and low tax rates encouraged production and entrepreneurial risk-taking, all of which worked together to increase the demand for dollars. The latter combination, whereby Volcker watched money supply growth and Reagan policies increased money demand, worked powerfully to reduce the excessive dollar supply-demand imbalance, which reduced inflation, pulled commodity prices lower and strengthened the foreign exchange value of the dollar. The dilemma over slow growth and high inflation was corrected and each man will be favored by history.

Fast forward to today, Ben Bernanke has the chance to seize this monetary moment before being confronted with the harsher extremes Volcker once faced. Rather than continuing to guess about the proper level of interest rates, Bernanke should do as Volcker once did and reject the Fed's targeting mechanism.

He should do so while setting a gold price target; the latter's stability a signal that dollar demand is matched by supply. These actions would stabilize the value of the dollar, immediately ameliorate the inflation environment, restore reliability to the dollar as an internationally recognized unit of account, and establish a sound monetary standard free of the distortions that promote inflationary cycles, including the one that threatens the economy as this is written.

Some would point to a hidden economic benefit relating to the theft, in that the neighbor, $500 poorer, might purchase enhanced home security to avoid future break-ins. The latter may be true, but spending there would merely detract from consumption elsewhere, not to mention that as opposed to generating any real economic activity, funds spent on home security would simply protect your neighbor rather than generate productive economic activity in the way that a $500 mutual-fund investment might.

The above scenario should be considered in light of the various calls for “economic stimulus” engendered by last Friday’s weak employment report. While the economists advocating stimulus dress up their plans in fancy rhetoric, stripped bare, their ideas greatly resemble the theft referenced above.

Former Clinton Treasury Secretary Lawrence Summers is the most prominent advocate of robust aid from Washington. In a Financial Times op-ed on Monday, Summers suggested “a $50bn-$75bn package implemented over two to three quarters would provide about 1 per cent of gross domestic product in stimulus over the period of its implementation.”

Notably, Summers was not advocating marginal income tax rate cuts across the board, but instead would like the federal government to issue rebate checks that would be put in the hands of Americans most in need. His view is that needy Americans would spend the rebates, thus “insuring against excessive declines in consumer spending that lead to reduced employment and further declines in incomes and spending.”

The errors in his thinking quickly become clear when we consider who among Americans actually pays taxes. According to the website ThanktheTaxpayer.org, the top 50 percent of American earners account for nearly 97 percent of all federal revenues.

If Summers’ plan is followed, rather than rob their more well-to-do neighbors, the bottom 50 percent of earners – the very people Summers would like to see showered with money – will simply let the federal government do their thieving for them. And rather than increasing demand in the economy by $50 to $75 billion, Summers’ economic-stimulus gimmick will merely shift spending from one set of hands to another. There will be no net increase in spending.

Worse for the economy, referenced above is the idea that the thieved might spend more money on non-productive home security to protect their wealth. Looked at in light of wealth redistribution by the federal government, the same concept will reveal itself; only in this case high-earning Americans will consume more capital on lawyers and accountants who, rather than generating positive economic growth, will only protect their clients from future governmental attempts to take their hard earned dollars.

Returning to the Americans Summers deems most in need of help, the single best way to alleviate financial uncertainty among the less fortunate is to let the successful among us keep what they earn. If they don’t spend all of their earnings, their excess capital, far from lying dormant, will be lent out to entrepreneurs and invested in the various companies that employ workers across the earnings strata.

Sadly, amidst all the hysteria generated by last week’s employment report, there’s very little talk of the federal government doing the one thing that would actually help less prosperous Americans. The latter are 100% reliant on excess capital that if not captured by the government, flows into companies in the form of higher wages for those in need.

In short, with economic growth apparently flagging, cheap attempts at class warfare mean that those most in need of economic help won’t get it. But if fixing the U.S. economy is indeed contingent on getting money into the hands of those who don't have it, true “stimulus” would necessarily involve taxing less those who do.

One would assume that most lawmakers are at least vaguely familiar with the history of American energy policy, not to mention past failed attempts to achieve the false god of energy independence. If so, their unwillingness to concede that these measures have produced the opposite of energy security (while propelling energy prices to record levels) at the very least raises questions.

Still, it is doubtful that these lawmakers, who rail against rising fuel or education costs, understand why food bills have barely nudged for the last 25 years. How, for example, did the price of corn remain at about $2.70 per bushel while the price of college tuition soared from $3,000 to $30,000? Unfortunately, the knowledge gap here has allowed them to be duped by the powerful farm lobbies that for years to come will reap a bonanza due to a combination of global food price inflation and farm subsidies. When we factor in the latest energy bill's potential impact on food prices, we can perhaps foretell further consumer unrest.

Funnily enough, the relative stability of food prices over the last three decades is a legacy of Cold War politics. Europe, poor and food deficient after WWII, and laboring under the illusion that commodities aren't fungible, created the Common Agricultural Policy (CAP) in the 1960’s in order to provide a buffer against Soviet encroachment. The CAP turned Europe into a major grain exporter by the late 1970’s. And after Mao’s failed industrial experiment in China, significant agricultural reform, including foreign investment and technology transfers following US President Nixon’s 1972 visit caused China’s grain production to quintuple in 5 decades, transforming it also into an exporter.

Elsewhere – in response to the CAP and US acreage set-aside programs, Argentina and Brazil multiplied their own arable land levels. The latter, combined with the aforementioned grain surpluses flowing from Europe helped to keep prices artificially low. The US similarly used export enhancement programs (cash bonus awards to exporters) to dump grain into North Africa and the Middle East to keep them out of the communist fold.

All of this changed with the end of the Cold War. Europe switched focus from food production goals to land conservation, causing its mountains of wheat to decline. Elsewhere, rapid emerging markets growth increased disposable incomes, raising the demand for foodstuffs; particularly meat and dairy products. China, reaching arable land capacity in 1995 has since seen acreage decline, and is resuming as a net importer. India, the world’s second largest wheat producer (and once an exporter), is today scrambling for foreign wheat to feed its burgeoning population. Pakistan, Russia and Ukraine have halted wheat exports and Argentina has increased its grain export tariffs.

And as the US remains open for business even within a cheap dollar environment (dollar weakness a frequently unsung factor in commodity boom of recent years), prices for wheat and soybeans reached record highs last week. Against this background of shriveling grain supplies and global monetary uncertainty, Congress has decided to embrace a misshapen form of autarky.

A review of the math of the energy bill reveals that the 2022 ethanol mandates of 36 billion gallons are equivalent to this year’s entire corn crop - a record 13 billion bushels and one that normally supplies 70% of the global export market. Even though the bill calls for half of all ethanol production to come from non-corn sources (e.g., woodchips), the technology for non-corn production is a decade away.

Grain prices are extremely sensitive even to minor shocks of supply and demand. While the post-Bretton Woods weak dollar in the early '70s factored heavily into the rising prices of all commodities, Soviet purchases of about 20 million tons of US feed grains and wheat sent prices soaring. Similarly, earlier this year, a decline in Australian wheat production caused global wheat prices to almost triple. The heavy levels of bio-fuel production mandated by the energy bill legislation will negatively impact the nation’s corn-reliant beef, hog and poultry markets; something that will force US consumers to pay up in the future when purchashing meats.

As for fuel efficiency, meeting the mandates for ethanol production with corn will provide a paltry 12% of the nation’s gasoline needs. Even the most sanguine experts claim that the conversion of corn into fuel adds only about a 34% energy boost, and some would say that the conversion process is a net negative. During planting, fertilizing, harvesting, drying and manufacturing, corn-based ethanol consumes almost as much fuel as it produces, and in the end, contains only 70% of the energy of gasoline.

Moreover, since ethanol cannot travel along gasoline pipelines, transportation of it insures even more fuel consumption. And speaking to the not-so-sanguine market view of ethanol, to protect its large US producers, Congress maintains a tariff of $.54 per gallon on the more efficient sugar-based ethanol made in Brazil.

Notably, the calories in the amount of corn needed to fill one SUV tank with ethanol, about 450 pounds, could feed one person for a year. While Americans will doubtless experience higher food prices under the bill, the least developed countries stand to suffer the most. Indeed, it is in poor countries that food costs frequently account for half of one's income. As it is, according to the UN, these countries have already seen a 25% rise in their imported food bills this year.

By adopting a large command-economy program that central planners would cheer, the US has renounced the market forces that drive the costs of the world’s most basic commodities. Sadly, this project will likely engender a chain of future interventionist policies - including rationing, price controls, and export halts - that will surpass what we experienced in the 1970’s.

Hailed by Speaker Pelosi as a triumph of American independence and bi-partisan cooperation, the energy bill is instead a remake of The Great Leap Forward – with potentially unsettling consequences ahead.

Ann Berg has served on the board of directors of CBOT, and is a frequent writer on issues relating to commodity prices.

Mainstream debate about Fed actions features an array of Keynesians calling for sharply lower funds rate targets, while various supply-side economists support steady or higher funds rates. The arguments coming from each side are surprising. Ordinarily, Keynesians theorize that a high funds rate target is requisite for central bank “credibility” in fighting inflation by inducing higher unemployment. By the same token, supply-siders often contend that higher economic growth permitted by lower funds rates will strengthen the currency. Sad to say, both sides err in accepting, if not supporting, abuse of the U. S. and world economy through Fed manipulation of domestic interest rates.

Preserving the Positive-Sum World

Eminent European economist Martin Wolf eloquently chronicles the historic importance of the world’s turn from “zero-sum” to “positive-sum” macro-economic thinking about two centuries ago. Since 1820, average real income per capita worldwide has risen 10-fold; 23-fold in the U. S. Central to the turn was the idea that everyone can progress by his own industry without diminishing the prospects of others. This overcame, and should have ended, ancient dogma suggesting a nation prospers only by gaining a positive trade balance against alleged trading "adversaries." Tragically, this discredited concept is resurgent, even dominant, in U. S. economic policy today.

Zero-sum thinking is apparent in the Keynesian insistence that the U. S. current account deficit is so ominous that it must be eliminated by devaluing the dollar. The U. S. dollar’s sharp decline since 2003, particularly since mid-2005, is praised by these economists as a positive path toward current account deficit reduction. Astonishingly, these economists advise deeper dollar devaluation for the same purpose, even while acknowledging as “inevitable” the collapse of U. S. asset prices as a consequence. Convinced that the current account deficit has negative implications, they advise destruction of the dollar and the economy to eradicate the risk.

As Wolf observes, we ought to be more intelligent than to allow zero-sum thinking to dominate us again. Wolf says it leads to political “… repression at home and plunder abroad …, a world of savage repression and brutal predation.” Yet, the Fed continues to ply manipulation of domestic interest rates with its funds rate “tool,” devaluing the currency for no purpose other than fighting trade wars to achieve positive current account balances. Currency devaluation is tariff protection by another name, enriching exporters and barring competition from domestic markets, all at the expense of the general populace. This is the essence of ancient mercantilism that classical economic theory and free trade policy overcame two centuries ago.

Mercantilist “Zero-Sum” Resurgence

Resurgence of mercantilist influence is neither coincidental nor recent. Eighty years ago, mercantilists stuck their noses back into the Republican political tent and imposed the Smoot-Hawley Tariff Act on the U. S. and the world. Franklin Roosevelt then delivered the Democratic Party to them, turning previously free-trading farmers into government-subsidized champions of trade barriers. Mercantilists won control of the Federal Reserve in 1971 after years of Keynesian whittling at the Bretton Woods pledge to keep the dollar’s value stable relative to gold.

Keynesian/mercantilist control of the Fed since 1971 has given the world the Great Inflation of the 1970’s: soaring oil prices, wage-price controls, gas lines, unaffordable housing, stagflation, double-digit interest rates and a “misery index” to measure the depth of “malaise.” The “cure” was the First Great Deflation of 1981-1982, collapsing oil prices, bankruptcies in oil producing infrastructure and a near-collapse of financial institutions due to falling product prices. Temporarily chastised, the Fed stabilized the dollar relative to gold during 1988-1996, but inexplicably sharply deflated by withholding liquidity in 1996-2001, causing a collapse of equity prices, first in Asia, then in the U. S. from 2000-2002.

Engineered Dollar Devaluation

The Fed added to its inane policy repertoire from 2004-2006 by raising the funds rate while injecting liquidity. This is a certain recipe for a devalued dollar - slowing economic growth while adding liquidity - and the proof is in the pudding. From $350/oz gold in 2003, the dollar’s value has dropped to $875/oz as this is being written. Supply-side economists should have detected earlier that raising the funds rate really does not “tighten” or otherwise drain liquidity. Yet many continue to support higher interest rate manipulation that penalizes domestic production while causing (yes, intentionally engineering) the devalued dollar and price escalations.

With no sign the Fed has learned that its policy mix of blundering and deception is causing great harm, including incipient trade wars, the European Central Bank cried “uncle” to the falling dollar. With European industry losing competitiveness even in its own markets, the ECB on December 18th announced a temporary injection of $500 billion in euros into its economy. As the World Trade Organization does not permit trade wars using tariffs, the ECB accepts the U. S.’s weapon of choice: competitive currency devaluations. The ECB has no alternative but to join the Fed in this dangerous game. Of course, this enables Fed supporters to brag that the dollar is “showing signs of strength” against the euro.

New Year’s Resolution for FOMC

Here is a worthy New Year’s resolution for every FOMC member: Heed Martin Wolf’s call to preserve positive-sum thinking which has done so much for worldwide prosperity. Stop the zero-sum manipulation of domestic interest rates. Float the funds rate and stabilize the dollar relative to gold by managing your portfolio of Treasury securities. Market processes will clear away the gathering storm clouds of credit strains in the early months of 2008, and the world’s future will brighten. ~

First, a “revenue-neutral” FairTax would reduce the taxes paid by tax-law-abiding Americans as a group. This is because the FairTax would collect taxes from people who have incomes (often large incomes), but do not now pay Federal taxes. These include drug dealers and illegal immigrants who work for cash, but also the 40 million foreign tourists who visit the U.S. every year.

Second, the FairTax would cause (pre-FairTax) prices to fall because it would lower the cost of doing business for every company in America.

The Congressional Budget Office (CBO) recently projected (August, 2007) that Corporate Income Taxes will total 2.7% of Gross Domestic Product (GDP) in 2008. Payroll taxes are expected to be 6.3 percent of GDP. Businesses pay half of these, or 3.2%. In addition, the costs to business of complying with the Corporate Income Tax are estimated to be approximately equal to the revenues this tax produces. However, let’s conservatively assume that these costs equal 2.0% of GDP.

Accordingly, the FairTax would reduce business costs by a total of 7.9% of GDP. This would cause (pre-FairTax) prices to the consumer to fall. Prices would not fall by the full amount of the FairTax, but they would fall.

Third, the FairTax would give Americans more money to spend. This would give consumers the wherewithal to pay the higher FairTax-inclusive prices built into what they buy.

The CBO estimates that personal income taxes will total 9.0% of GDP in 2008. Employees pay the other half of payroll taxes, or 3.1% of GDP. The Death Tax collects 0.2% of GDP. In addition to the taxes they pay, individuals incur considerable costs in complying with the Federal tax code. Let’s (conservatively) assume that these amount to 2.0% of GDP.

The FairTax plan provides for a “Prebate” in the form of a monthly check that would be sent to every family in America. The Prebate is equal to the FairTax the family would pay if it earned and spent an income at the official government “Poverty Line” (about $27,000/year for a family of four). The Prebate will ensure that Americans pay no net FairTax on the “necessities” of life. Prebates will equal about 3.2% of GDP, replacing other income-support programs that total 0.4% of GDP.

Because of lower costs, business would be able to reduce their prices by up to 7.9 percent of GDP, while individuals will have additional spending money equal to 17.1% of GDP. Together, these equal 25.0% of GDP. At its proposed tax rate of 23% (inclusive rate), the FairTax would generate Federal Revenues equal to about 18.6% of GDP. Accordingly, this simple “static analysis” shows that the American people would be way ahead with the FairTax.

Most of the benefit would come from eliminating the enormous compliance and administration costs of the existing tax system. However, based upon the CBO projections for 2008, the FairTax at a 23% rate would provide a tax cut that would bring the Federal government’s “tax take” from the historically high level projected for 2008 (19.2% of GDP) down closer to its average for the past 40 years (18.0% of GDP).

Now, so-called “deficit hawks” argue that we should be raising taxes right now, not cutting them. Many of these people suggest that the 2003 Bush tax cuts should be allowed to expire. This would raise the Federal “tax take” by about 2.0% of GDP.

It is impossible to make a rational case for tax increases based upon either the Federal Deficit or the National Debt. The CBO projects a 2008 Federal budget deficit of only 1.1% of GDP and a “Debt Held by the Public” of 35.9% of GDP. Both numbers are low by historical standards, and are low compared with Europe and Japan.

Instead, tax-increase-advocates generally point to the huge “unfunded obligations” of Social Security and Medicare. In their 2006 Annual Report, the Social Security Trustees estimated the “present value to the infinite horizon” (PVIH) of these “unfunded obligations” at $86 trillion.

Given that the corresponding number for future Federal revenues is about $201 trillion (18.0% of the $1117.3 trillion PVIH of future GDP), this is a crushing financial burden. To close this gap via tax increases, Federal taxes would have to be raised by 43% across the board (from 18.0% of GDP to 25.7% of GDP). Moreover, this would (somehow) have to be accomplished with no impact on economic growth. A reduction of only 0.5 percentage points in our long-term average annual real economic growth rate (to 1.4% from the Trustees’ projected 1.9%) would nullify this enormous tax increase and bring the PVIH of Federal revenues back down to $201 trillion.

The FairTax would provide a tremendous boost to economic growth. That is because it would reduce taxes on saving and investment to zero. Economic growth is purely a matter of private capital investment. The more we invest, the faster the economy grows. If Americans did no more than reinvest the taxes that they no longer had to pay on savings and investment and the associated compliance costs, this would be sufficient to raise our real growth rate by 1.4 percentage points.

What difference would it make if America grew at 3.3% per year rather than 1.9%? Well, at a long-term average annual real economic growth rate of 3.3%, the PVIH of future GDP is infinity. This would make the PVIH of future Federal revenues also equal to infinity—at any FairTax tax rate.

Eighteen percent of infinity is more than 18.0% or 20.0% or even 25.7% of $1117.3 trillion. America needs the FairTax.

Q. Why do you think that a sales tax is less prone to corruption and complexity than an income tax?

A. There are three major reasons that the FairTax would be less problematic than an income tax:

1. It applies to actual transactions where money changes hands, rather than “income”, which is a concept so abstract as to be almost ethereal. Most of the 60,000-page U.S. tax code deals with the definition of “income”.
2. There would be only about 20 million entities that would need to file FairTax returns, compared with 140 million who must file income tax returns now.
3. At the proposed 23% (inclusive) rate, the FairTax rate is much lower than the current 35% top tax rates on personal and corporate income. The lower the rate, the less incentive for avoidance, evasion, and special pleading.

Q. Are sales taxes, where they are currently in operation, simple and free from special interest lobbying?

A. Nothing in the manifested universe is perfect, but sales taxes are, in practice, simpler and less prone to special interest lobbying than income taxes. Right now, the huge Washington lobbying industry on K Street gets half of its revenue from lobbying the income tax code.

Q. Does it apply to non-profits?

A. The FairTax applies to retail sales of new goods and services. If a non-profit sells new goods and services, it will collect the FairTax on them. However, in general, charity involves giving things away, not selling them. Also, the FairTax would eliminate the payroll taxes that non-profits pay under current law.

Q. Are used goods, non-taxable?

A. Yes—the FairTax applies only to sales of new goods and services. However, the nation as a whole obviously cannot replace newly-produced goods with used goods. If I sell you my car, I don’t have it anymore. All of the new parts and labor that would go into “rehabilitation” and “refurbishment” of used items would be subject to the FairTax. This having been said, the FairTax would shift U.S. GDP from current consumption toward investment and exports. Most economists would applaud such a move.

Q. What about the transition period?

A. People respond to incentives, and there would be an incentive to delay income and accelerate spending ahead of the FairTax effective date. This could well result in a short-term increase in debt. However, debt will be easier to repay under the FairTax because people will have more take-home pay. This aside, America has been around for 232 years. There are many things that could be done to ease the transition, and it makes no sense to avoid a change with huge long-term benefits because of one-year transition effects.

Q. Isn’t it true that the rate is not really 23% but 30% at least, because it’s tax-inclusive?

A. Yes and no. Both the FairTax and the income tax can be stated as either an “inclusive” or an “exclusive” rate. For an “apples to apples” comparison with the rates of our existing tax system, the 23% “inclusive” FairTax rate is the correct number to use.

Q. How do we determine the interest portion of mortgage payment?

A. Interest above the rate on 10-year Treasury bonds is subject to the FairTax. This will prevent suppliers from discounting prices and making it up with high interest rates on financing. The 10-year Treasury rate is a market-determined interest rate that is not targeted by the Federal Reserve.

Having addressed the “content” of Mr. Bowyer’s questions, I would like to turn to the more fundamental issue of “context”.

A “contextual” question that shapes a person’s entire experience of life is, “Is the glass of life half empty, or is the glass of life half full?” Think about the people you know and you will see that this is true.

The analogous political question is, “Is the glass of America half empty, or is the glass of America half full?” The FairTax is an expansive, optimistic, “half full” concept. It has a natural appeal to people for whom the glass of life, and the glass of America, is half full. The FairTax speaks to “possibility” rather than “fear”.

I do not know Mr. Bowyer personally, so all I can say is that his questions about the FairTax struck me as coming from a “half empty” point of view. This was not surprising to me. Most “elite opinion”, including virtually the entire Mainstream Media, has embraced the “the glass of America is half empty” point of view and has dedicated itself to proving this position right.

The FairTax is about America’s future. When it comes to matters pertaining to the future, facts and logic cannot bridge the gulf between hope and fear, the chasm between “half empty” and “half full”. All we can do is to pose the question to the American people and let them decide.

Beyond the perhaps understandable displeasure some have with government funds moving into private industry, the principle fear when it comes to Asian and Middle Eastern SWFs is that if their investments in U.S. firms become large enough, they might eventually aggregate to themselves a more controlling role in the firms they invest in. Maybe, but if the latter scenario materializes and proves problematic from a business standpoint, there will be no need for government intervention.

Indeed, individual and institutional shareholders, with their money on the line, will quickly correct poor management decisions by selling their shares. SWFs, presumably chastened by actions that reduce the value of their holdings, will necessarily moderate their management to reverse any negative market responses. And to the extent that other SWFs choose to invest stateside in the future, they’ll do so with full knowledge of what investors will and will not accept.

Most important, public and private companies in the U.S. serve at the pleasure of their shareholders, as opposed our federal government. As such, it should solely be up to the owners of companies to decide not just the origin of investment, but to whom they’ll sell their shares.

From a jobs perspective, Merrill Lynch and Citigroup alone employ hundreds of thousands of workers. If politicians love jobs as they say they do, they must also welcome investment. Absent the financial commitments made to Merrill and Citi by Temasek Holdings (Singapore) and the Abu Dhabi Investment Authority, the job prospects of both firms’ employees would be far more tenuous. Those concerned about foreign investment they deem unseemly must consider the alternative of people being put out of work.

When it comes to trade, mercantilist politicians from both sides of the aisle regularly express their displeasure with our mythical trade deficit. They also consistently rail against money being sent overseas, but as the actions of certain SWFs indicate, those dollars must eventually return to the United States; in this case as investment in blue chip investment firms. And while the aforementioned investment won’t factor into governmental calculations of our trade deficit, we should consider this a “teaching moment” for those who presume trade doesn’t balance. We let others make for us what’s not in our economic interest to create, and the money returns in many forms, including as job creating investment.

Furthermore, with the dollar’s weakness already well-chronicled, would we prefer that SWFs hailing from the “wrong” parts of the world simply exchange their dollars for euros, pounds and yen? If we ignore how actions such as this might weaken the dollar further, would we somehow feel better if instead of investing in American companies, the sovereign funds in question were to re-direct their capital to France, England or Japan?

Perhaps most importantly, cross-border investment and trade is probably the purest form of “soft diplomacy” that exists. Just as we as individuals wouldn’t lend money to or invest in people we wished harm, capital inflows from parts of the world some consider threatening represent the best way for warring cultures and countries to achieve peaceful relations. Simply put, enemies real and imagined are far less likely to point a gun or aim a missile at countries guarding their capital.

To President Bush’s credit, he has made plain his sanguine nature when it comes to foreign investment while noting that a bigger mistake would be for us to “say we’re not going to accept foreign capital, or we’re not going to open markets.” Still, as the Journal article made clear, fear of a negative reaction from Washington is a growing concern among companies with capital needs, and that’s too bad.

Irrespective of their geographic locale, fear of SWFs is overdone. To the extent that Washington usurps the role of markets in sorting out government-sponsored investment, its actions will harm the U.S. employment picture, weaken the already flagging dollar, and perhaps worst of all, make the world a scarier place.

Strangely, the credit is likely due primarily to the U. S. armed services, since no other currency is defended adequately to qualify as the world’s reserve currency. If the trading nations of the world place large amounts of wealth reserves in a currency whose issuer is then placed under siege by international terrorism, which currency other than the dollar will be secure? None readily comes to mind.

Crisis in the European Monetary Union

The euro is the best alternative candidate, but it has additional problems, some of its own making and others that derive from U. S. policy. Euro strength relative to the dollar aside, the European Monetary Union is in danger of coming apart. The reason is not cultural or nationalist disunity. Economic growth in the northern tier of member nations is outstripping growth in the southern tier. Interest rates on government bonds in Spain, Italy and Greece are rising to historic highs relative to German bond rates. This leads to higher government deficits, higher tax rates, lower real wages and lower growth in the southern tier. The economic spiral is moving dangerously in the wrong direction, and southern EMU members may withdraw.

The EMU dilemma appears complex, perhaps beyond satisfactory resolution, because conventional economic wisdom advises higher tax rates and higher interest rates when budget deficits and inflation are problematic. That advice, if followed, means more unemployment and lower wages. The crisis is deplorable, partly because such disunity among neighboring nations is not good for global progress, but also because it results partly from U. S. monetary policy.

Bad Vibes from the Federal Reserve

The Federal Reserve is the most important central bank in the world due to the size and strength of the U. S. market and to the U. S. role in global security. In this context, every other central bank must follow the Fed’s lead in theory and policy. Since 1971, the Fed’s lead has at times been ill-advised and unsuccessful in the extreme. At this writing, the dollar is trading at its historic low value relative to gold, not reached previously even in the monetary debacle of 1980. Will the Fed reverse course, as it did in 1980-1982, and drive the dollar’s value upwards again? By present Fed practices, only time will tell. Yet the answer is all-important in forecasting profits and commodity prices.

The Fed’s moves with the dollar are also highly important to the ECB and to EMU members. As the Fed manages the dollar, the ECB manipulates domestic interest rates and liquidity to position the euro’s value relative to the dollar, while EMU member governments manage government spending and tax rates. Orchestrating these variables successfully is almost impossible, particularly with the dollar value changing so drastically. This is so even if their economic theories are correct.

Invalid Keynesian Monetary Theory

Complicating the EMU problem is the reality that the economic theories of the Fed and the EMU are invalid. Raising interest rates to slow production, cut employment and slow economic growth does reduce wage growth and economic growth, but it does not reduce monetary inflation. Higher interest rates reduce demand for dollars, thus actually creating greater excess liquidity and inflation. The Fed does this with the dollar, and the ECB and EMU attempt to emulate the conduct among the nations of Europe. Little wonder individual nations cannot uniformly trace the course the EMU wishes to follow.

Fed governors and staff must know their actions actually weaken the currency. Indeed, they are praised by their Keynesian brethren for doing so. As it happens, academic Keynesians welcome dollar devaluations engineered by the Fed, even at the cost of collapsing U. S. corporate equity share prices, in order to relieve their angst over the current account deficit. In the Keynesian model, “managing” the dollar’s value is all about trade war: winning through currency manipulation.

Funds Rate Manipulation

The Fed’s handling of the funds rate is about something different. As I concluded back in 2007, the dollar’s weakness is determined by the Fed’s handling of liquidity, which is not dependent on the funds rate. Now a new study at the St. Louis Fed confirms by statistical analysis essentially what I saw in macro-analysis: “Contrary to conventional wisdom – that the Fed controls the federal funds rate through open market operations – [the data show] little support of an important liquidity effect….” The data cover 1986-1996, but bolster the essential point previously made. The funds rate target is not the valve governing flow of Fed liquidity to and from the economy. The Fed’s continuing use of it is indefensible, as the funds rate serves only to set anti-competitive prices for bank credit costs and to manipulate asset prices.

The Fed should allow the funds rate to be set by market forces and manage liquidity to achieve dollar stability at a stated gold price. The overnight funds rate would decline to a normal yield curve, meaning lower than short-term Treasuries (the 2-year note is about 2.65%, the low point on the existing yield curve). Financial intermediaries could then relieve the “crunch” affecting credit markets. The cost of credit to small business and consumers would drop by another 2%, permitting the U. S. economy much better prospects of growing rather than receding.

Best Chance for EMU and the U. S.

More importantly for the EMU, a stable dollar and market-set interest rates would make EMU issues considerably more manageable. The ECB could stabilize the euro using the same policy recommended to the Fed, allowing market-set interest rates and managing liquidity to a gold price in euros. EMU member states could then concentrate solely on fiscal policy, cutting marginal tax rates in the southern tier to achieve economic growth comparable to what is presently being experienced in the north. Europe would welcome this, as its pre-eminent economist Martin Wolf has proposed returning to a Bretton Woods system of fixed exchange rates. Wolf, as is well known, rightly deplores mercantilist monetary practices.

Reform of Fed policy is important and urgent. Public policy of this scope, when demonstrably so counter-productive, is fully capable of causing serious dislocation and breakdown in the global economy. U. S. elections and equity markets, and far more, are at risk. Regardless of claimed Fed independence, the people hold the president and his party responsible for the economy and the dollar. The culprit is the Fed. If the Fed won’t reform its practices, the president must act. ~

In contrast, the PV of the “unfunded obligations” of Medicare and Social Security total almost 43% of the PV of future Federal tax revenues. Throw in the Treasury debt and unfunded Federal retirement benefits, and you get “debts” that equal $95.8 trillion, which is almost 48% of the PV of future Federal tax revenues. Given the other needs to which the Federal government must devote tax revenue, this debt load is financially unbearable.

The government’s financial problem could be solved simply by cutting promised Social Security and Medicare benefits drastically. However, this is considered politically impossible, so what is generally discussed is a combination of tax increases and benefit cuts. Unfortunately, any kind of tax increase would almost certainly make the government’s financial problems worse.

What is not widely understood is how sensitive Federal finances are to economic growth, and how sensitive long term growth rates are to tax rates; particularly those on capital. The “present value” calculations that the Social Security Trustees use to estimate Social Security and Medicare “unfunded obligations” tell the tale.

The Trustees (2006 Report) estimate the PV of future Gross Domestic Product (GDP) at $1117.3 trillion. The current Federal tax structure captures about 18% of GDP, which puts the PV of Federal revenues at $201 trillion. The purpose of a tax increase would be to increase the PV of Federal revenues. If it didn’t do that, it would do the government no good.

Congress traditionally estimates the revenue impact of tax changes via “static analysis”, which assumes that tax changes have no impact upon the economy. Static analysis would say that the Federal government’s financial problems could be solved by simply increasing all Federal tax rates (income taxes, corporate income taxes, payroll taxes, etc.) by 48%. This would increase the Federal government’s take “take” from the current 18% of GDP to 27% of GDP. This, in turn, would increase the PV of future Federal revenues by $95.8 trillion and offset all Federal “debts”.

Unfortunately, static analysis isn’t realistic. Whatever you tax you will get less of, so any form of tax increase will slow economic growth. In the real world, it is surprisingly difficult to increase the PV of future Federal revenues by raising tax rates.

Furthermore, a 48% across-the-board tax increase would cause another Great Depression. However, let’s say that it didn’t. If such a tax hike cut the long-term real economic growth rate by only 0.55 percentage points (from the Trustee’s assumption of about 1.9%), there would be no increase in the PV of future Federal revenues at all. Financially, the Federal government would be back where it started, while the PV of future income available to the rest of the nation would be cut by more than 40%.

Taking a less extreme case, many are calling for reversing the 2003 tax cuts. Static analysis would say that doing so would increase the Federal tax “take” to about 20% of GDP from the current 18%. However, if this huge tax increase cut our average long-term growth rate by only 0.12 percentage points, the Federal government would be no better off (and the rest of the country would be much worse off). Given the massive increases in GDP growth and Federal revenues that followed the 2003 tax cuts, reversing them would be insanely risky from a financial point of view.

So, if the Federal government’s financial problems can’t be solved by raising taxes, what can be done? The Social Security Trustees’ financial methodology points to the answer: cut tax rates to achieve faster GDP growth.

GDP growth is most sensitive to taxes on capital, especially to the Corporate Income Tax (CIT) and the Death Tax. Repealing the CIT and the Death Tax would cut the Federal tax “take” from 18% of GDP to about 16%. Evidence from around the world suggests that doing this would cause economic growth (and wages) to skyrocket. Tax cuts much smaller than this propelled Ireland to an average GDP growth rate of over 7 percent for the past ten years.

But let’s say that GDP growth didn’t skyrocket. If these huge tax cuts increased long-term GDP growth by only 0.13 percentage points, they would “pay for themselves”, in the sense of maintaining the PV of Federal revenues. If they increased growth by only 0.45 percentage points, they would increase the PV of future Federal revenues by $95.8 trillion, thus offsetting not only the tax cuts, but all Federal “unfunded obligations”, including the “national debt”. At the same time, the PV of the income available to the rest of us would increase by more than 75%.

Obviously, cutting taxes would require additional Federal borrowing for a few years. However, the financial markets would be eager to provide the funds because they lend based upon their calculations of the PV of future Federal revenues, which is what determines the government’s ability to service its debts.

With the economy on a fast growth track, the Federal “deficit” would melt away, as it did in the late 1990s and is doing right now. Future Social Security Trustees Reports would say that the Social Security + Medicare “unfunded obligation” problem was disappearing.

Meanwhile, real wages would start growing rapidly again, as they did in the 1960s. The nation would finally have the experience of real prosperity. Cutting—not raising—taxes is the way out of the Federal government’s financial hole.

The gold futures market is also unlike any other commodity futures market because it is the only one where the front month price is always lower than its future price. In traders’ speak, gold futures are always in contango and have NEVER backwardized. This means that supply and demand have very little, if any, effect on the price of gold. Conversely, other commodity futures markets backwardize during temporary spikes in demand or supply shortages. A recent example was the oil market after Hurricane Katrina when spot oil prices sky-rocketed higher than future prices due to supply shortages.

Because of gold's unique attributes, which are continuously validated by its futures market, the assertion that voracious demand from overseas has caused the dramatic rise in gold prices has no basis in fact. More realistically, the changes in the price of gold that we've witnessed are really a consequence of the changing value of the currency in which gold is denominated - not the changing value of gold itself.

As a result, the price rise in gold from $350 in 2003 to nearly $900 today indicates that the dollar has lost more than 60% of its value. In other words, where $1 bought you 1/350th of an ounce of gold in 2003; it now buys you 1/900th of an ounce. The dollar is truly buying less these days, and many consumers hit by rising fuel and food costs would agree.

Because gold holds its real value relative to goods and services, another way to think about this rise is to realize that the broad price level will have to increase to keep up with gold. Therefore, the 150% jump in the gold price means the cost of everything else in the price universe will eventually have to catch up if the dollar's fall is not corrected. Prices for commodities (such as oil and copper) usually adjust the fastest, while regulated prices (such as stamps) usually take the longest time. This price adjustment can take years or decades, and often times prices over and under-shoot because of the continued volatility of the dollar-gold price and the dislocations this causes for producers of these goods and services.

If one thinks about gold as an inflation indicator like this, it really becomes an inflation index. When gold rises X%, the broad price level of the economy (or inflation) will eventually increase by about that much; and vice-versa when gold falls. Therefore, indexing gold for CPI or other inflation statistics doesn't make sense. It's equivalent to adjusting an inflation measure for another inflation measure!

So during this period of record high gold prices, we should remember that gold is expensive because the dollar is weak and excessively abundant in supply. And furthermore, we shouldn't be adjusting gold for inflation, but instead should recognize that gold itself is an inflation indicator forecasting an incipient rise in the general price level of dollar-denominated goods and services.

Owing to what Brooks considers a changing Republican electorate, policies must shift given his belief that, “The entrepreneur is no longer king.” Instead, with anxiety levels rising among America’s middle class, the “wage-earner” has taken away the king’s crown. The contradictions in this presumed abdication are many.

First off, to whom should workers give thanks for their wages other than to entrepreneurs? Any policy centered on wage earners that doesn’t elevate the entrepreneur is the equivalent of cheering sunlight while ignoring the role of the sun. You can’t have one without the other, and it is entrepreneurs who sense unmet needs in the marketplace, attract the capital necessary to fulfill those needs, and who deploy that capital in myriad ways, including for the purpose of hiring the less entrepreneurially minded among us.

Touched on above is the truth that entrepreneurs can only innovate and hire if capital is plentiful. And as very few prominent businesses today can attribute their success to the Small Business Administration, entrepreneurs find themselves reliant on individuals willing to forego current consumption in favor of the often distant object of investment success. Of course, the amount of investment capital made available for job-creating businesses is directly correlated with how much or how little governments take from the current and future earnings of individuals. In short, without free capital there are no wages to begin with, so for Brooks to go wobbly on cutting tax rates is for him to implicitly suggest that wages should fall altogether.

Brooks might argue that Republican policy should be concentrated on the large and established wage-paying businesses in the U.S. versus the various small firms that dot the landscape, but that’s a distinction without much of a difference. All businesses, from old-guard institutions such as Ford Motor Co. and the New York Times Co. to modern capitalist marvels such as Amazon and Google, were once entrepreneurial ventures that started out small.

To the extent that there’s a difference, it reveals itself in the multiples investors will pay for the earnings of the old versus the new. It is there that we see what investors truly value, and the simple fact that they value the future earnings of Google far more than they do those of Ford speaks volumes to the staggering importance of entrepreneurs to our economy. Successful entrepreneurs attract capital, and the latter funds jobs.

For evidence of what economies look like when they’re entrepreneur-deficient, we need only look to Michigan, where the Republicans held a primary just this week. The state’s dismal outlook speaks to the folly of de-emphasizing the entrepreneur to the alleged benefit of the wage-earner. Politicians in Michigan have been doing this for decades; vainly attempting to save the jobs provided by sclerotic, old-economy automobile behemoths of yesteryear, all the while keeping taxes so high that entrepreneurs with new ideas have taken their skills elsewhere. At present the state has the nation’s highest rate of unemployment to show for all of its efforts. It says here politicians of either party won’t be talking economic “Marshall Plans” when their campaigns take them to entrepreneurial hotbeds Palo Alto, Cambridge and Austin.

Ideology aside, Brooks reasons that tax cuts must be shelved in order to pay for unfunded promises made to an “aging society,” not to mention the costly nature of new campaign promises made by allegedly enlightened Republicans which include wage subsidization, birth savings accounts, federal 401(k)s, and “personal re-employment accounts.” If we ignore for now how far afield some Republicans have strayed from the Party’s ideological moorings, it should at least be remembered that as federal revenues have pretty consistently amounted to 18 percent of GDP irrespective of the tax rate, the policy answer for newly generous Republicans should not be one of shunning tax cuts.

Instead, with Republicans apparently planning to shower all manner of new entitlements on their voters, the importance of the entrepreneur and tax cuts becomes even greater. Somehow these programs will have to be paid for, and as successful entrepreneurs by definition create wealth and high-paying jobs, the U.S. will need a flush tax base to fulfill the promises made by its politicians.

Brooks thinks differently, and applauds the Republicans who “are shifting focus right now” from a tax-cutting, entrepreneur-focused ethos that as recently as 2006 had the Party in control of all three branches of the federal government. Perhaps channeling this new focus yesterday, President Bush signaled his willingness to put off extension of his 2003 tax cuts in return for quick passage of an economic "stimulus" bill that promises not to stimulate. The Dow Jones Industrial Average quickly fell 300 points. The market's mood suggests investors are far less sanguine than Brooks about the new path taken by certain Republicans.

“There is no subtler, surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.”

At this point, we must all hope that Ben Bernanke is Lord Keynes’ “one man in a million”. The markets have lost confidence in the dollar, and the resulting fears about the future are causing economic decision-makers to pull back with respect to production, hiring, and investment.

If you want to understand how concern about an unstable dollar could cause a recession, imagine if tomorrow the U.S. Bureau of Standards announced that it was “floating” the foot. Instead of being fixed at 0.3048 meters, the length of the foot would henceforth be set by “the market”. This would impact not only economic arrangements based upon length (property lines, lumber sold by the foot), but also every transaction involving area (flooring is sold by the square foot) and volume (“the gallon” is legally defined as 231 cubic inches).

Even before there was any change in the market length of the foot, there would be a massive redirection of economic energies and focus. Executives would turn their attention from production, trade, and investment to protecting their interests from possible changes in the value of the foot. Transactions would be delayed or cancelled. Just the existence of the possibility that the foot could change in length would cause economic chaos.

Just as “the foot” is our basic unit of length, “the dollar” is our fundamental unit of market value. The smooth, efficient operation of the economy depends upon stable units of measure. Unfortunately, the dollar has become highly unstable.

This is a very strange situation. Because the Federal Reserve has the power to set the size of the monetary base (i.e., the number of “dollars” in the world) anywhere between zero and infinity, the Fed has total control over the value of the dollar. Unfortunately, the Fed seems to lack the understanding necessary to use its power wisely.

The underlying problem appears to be intellectual confusion between “money” and “capital”. Because the Fed is both the monetary authority and a bank (“the lender of last resort”), it deals with both. Unfortunately, right now there seems to be considerable confusion between the Fed’s two roles.

In its role as the monetary authority, the Fed’s job is to meet the market demand for the monetary base while keeping the value of “the dollar” stable. In its role as a bank (the lender of last resort), its job is to keep the banking system operating smoothly. The Fed has the necessary tools to do both of these important tasks, but lately the Fed has been doing the equivalent of using a hammer to change a light bulb.

The confusion between “money” and “capital” is embedded in the Fed’s practice of targeting the interest rate on Fed Funds to control the size of the monetary base. The monetary base is “money” and every interest rate is the price of some form of “capital”.

Monetary control based upon intellectual confusion yields an unstable dollar. Here is how it works. What it means for the Fed to have a Fed Funds target of 4.25% is that the Fed adjusts the size of the monetary base to keep the interest rate on overnight loans among the 1000 or so Federal Reserve member banks at 4.25%. In turn, what this means is that the Fed is keeping the value of “the dollar” equal to the value (in the Fed Funds market) of a promise by a Fed member bank to pay $1.00011644 tomorrow. By targeting the Fed Funds rate, the Fed literally defines the value of “the dollar” in terms of itself. This practice makes the value of “the dollar” indeterminate, and therefore inherently unstable.

Monetary control based upon targeting an interest rate can work if there is high market confidence in the value of the dollar. Once that confidence is lost, however, the fatal flaw in this approach is exposed and the costs to the economy begin to escalate.

Can the dollar be saved? Of course it can.

The Fed should announce that it is abandoning the targeting of the Fed Funds rate and will henceforth express its monetary policy in the form of a target range for the COMEX price of gold. It should further announce that it will use Open Market operations to force the price of gold down until it is trading in a range of $505 maximum, $500 minimum.

While the dollar is being stabilized, the Fed can use its capabilities as a bank to relieve any strains that might appear in the banking system. It would do this by selling government bonds and buying other types of financial assets from whatever institutions needed liquidity. The Fed is already doing this to help deal with the fallout from the “sub-prime” debacle.

I humbly predict that this approach would cause gold prices to plummet, the dollar to soar, interest rates to plunge, talk of recession to vanish, the monetary base to expand, and speculators to file for bankruptcy. It would be fun to watch.

The underlying economic problem today is economic participants are less willing to take risks to produce. The S&P 500 has lost 15% since its October 9th high. Meanwhile, the spread between selected junk yields and the 10-year Treasury has widened from 310 basis points to 542 basis points. Widening credit spreads indicate a reluctance to take risk; the last time we witnessed such a sharp widening amidst an equity market pullback was 2000 through 2002. Not surprisingly, the 2001 tax rebates did little to improve market and risk-taking sentiment. But the 2003 tax cuts did, as credit spreads finally narrowed to more normal levels - and stocks soared.

Today’s aversion to risk has been arguably caused by the increasingly negative and uncertain fiscal, regulatory and monetary outlooks.

On the fiscal front, the tax outlook worsens by the day. House Ways & Means Chairman Charlie Rangel has not followed through on Nancy Pelosi's promise in October 2006 to keep the cap gains and dividend tax cuts. At this point, the tendency of the Democratic Party at large is to either allow the sunsetting of these tax cuts or at the very least rescind them from the highest income earners. Rangel is also failing to permanently correct the increasing burdens of the AMT. All the while, the weak dollar marked by rising gold is, in my estimation, doubling effective tax rates on capital; and marginal income tax rates are being under-adjusted by 4%, causing a real bracket creep akin to the 1970s, albeit to a lesser degree.

The unintended consequences of Sarbanes-Oxley also remain, such as capital flight to foreign markets and burdensome costs that coincidentally create barriers to entry for entrepreneurial start-ups. And the 2005 bankruptcy bill is arguably worsening today’s subprime crisis because it no longer allows households to wipe away credit card debt. As a result, households hanging by a thread are being forced to choose between which of their major debts to service: plastic or mortgage. Capital One Financial Chief Executive Richard Fairbank said on November 5 that households are deciding to "let the house go." This of course only worsens the crumbling housing market and reduces the values of the assets collateralizing mortgages and specifically subprime paper.

On the monetary front, the Federal Reserve's discretionary monetary policy of fed funds targeting is failing to restrain inflationary pressures for the second time since its original inception in 1974. The first time it failed (between 1977 and October of 1979 Paul Volcker abandoned it), it was abundantly clear that targeting the cost of credit to control money supply growth was utterly ineffectual. Today, Ben Bernanke and his FOMC colleagues are attempting to control both the price level and economic growth with this same lever based on Phillips Curve principles that run contrary to classical economic theory. But today's weak dollar and slowing growth problems require two distinct policy prescriptions: a gold-price policy target to directly and efficiently control the monetary spigot combined with tax relief and simplification to ignite risk-taking. Undoing Sarbanes Oxley and bankruptcy regulation would help, too.

Jude Wanniski often said, "There is no growth without risk, not only in economics but politics and daily living." Our fiscal, regulatory and monetary problems need repair. The question facing President Bush and his Administration is: will they increase the economy's appetite for risk to reinvigorate growth, win the electorate, and solidify a proud economic legacy?

In doing so, there will be a very tiny incentive effect, although it’ll only last a year. As I said, the president is making the best of a bad political situation. He had to do “something.” And this is the least harmful thing he can do. It can be classed as income-tax relief, even though there’s no permanent incentive effect.

The better part of the stimulus plan is the inclusion of a business tax cut that will probably be a 50 percent cash-expensing bonus for the depreciation of new equipment, plants, or structures. This is very good. It worked between 2002-07. It recently expired, so it’s a good time to renew it. The Democratic Congress may fight him over this, but the president is willing to join that battle. Good for him.

Senator Arlen Specter has a related bill that would permit full expensing for new investments put into place during the tax years 2008-09. Sen. John McCain has just released an even-better plan that would permanently slash the corporate tax rate from 35 percent to 25 percent. It also would allow both the expensing of equipment and technology investments, and would establish a permanent research-and-development tax credit. By lowering the cost of capital and raising the investment return, this would really be a booster-rocket for economic growth, jobs, and real worker wages.

Supply-side guru Jack Kemp helped pilot this proposal through the McCain camp, and the senator announced it yesterday. Now we’ll see if Democrats are willing to provide some tax incentives for business and accept President Bush’s offer. While Bush did not include a permanent feature for his capital-gains and dividends tax cut as part of his short-run plan, he did make it clear that he intends to pursue this later on.

Incidentally, Fed chair Ben Bernanke suggested yesterday that making dividend tax cuts permanent would provide near-term stimulus by boosting markets. That’s an important golden nugget in his otherwise lackluster presentation. (Hat-tip to Strategas political analyst Dan Clifton for this. I also saw it in the Real Time Economics blog of the Wall Street Journal.)

While none of these short-term fixes are going to expand the economy’s long-run potential to grow, at least President Bush attempted to stay on the supply-side of tax policy in the current Washington panic over the economic slowdown and stock market plunge.

Unfortunately, stocks are falling yet again today. I still don’t know why Bernanke didn’t cut the fed funds rate 50 basis points this week in advance of the January 30 meeting.

The choice for the family would be basically this: double your money or double down on "young Arthur," as the NYT's Chairman and CEO is sometimes called. In the back of their minds, the prospect of doubling down on "young Arthur" could only mean that the company's stock will continue its relentless decline. The prospect of doubling up with Google offers realized value, a global platform and thus a much clearer path to future growth. Everyone would be a lot richer than they are now. Assuming a cash/stock transaction, some might be a whole lot richer in the future.

I am told by smart people who know the business that the Sulzbergers will never sell; that their identity is the New York Times. It's also said that they take their role as stewards of journalistic "excellence" and "integrity" seriously. They're plenty rich as it is, if not as rich as they once were, so it's not about the money. It's about the Statue of Liberty and justice and righteousness, all of which they feel The New York Times embodies. And I believe that they believe all that.

But as everyone knows, and the Sulzbergers know better than most, the game has changed. Classified advertising has been gutted by Craig's List (and a thousand other web-sites). Department stores have consolidated and newspaper advertising budgets have consequently declined. The way people access information has fundamentally changed, thanks to the Internet. On and on it goes.

But perhaps the biggest change is that The New York Times is squarely in the cross-hairs of the aforementioned Rupert Murdoch. Mr. Murdoch recently acquired Dow Jones for $6 billion. He did not buy Dow Jones because of its growth potential. It's a mature business, to say the least. He did not buy Dow Jones because he sees limitless growth opportunities in financial news and business information. It's a crowded field. He bought Dow Jones so that he could own The Wall Street Journal. He intends to use The Wall Street Journal as a precision-targeted weapon. And the target he has locked onto is The New York Times.

The Sulzbergers understand this. The question they have to ask themselves, knowing that Mr. Murdoch intends to bleed them to death, is this: Can they afford to engage in this battle without a very deep-pocketed partner or do they sell the New England properties (The Boston Globe, NESN, The Boston Red Sox stake and the Worcester Star-Telegram) and use the proceeds to fund the counter-offensive? Given "young Arthur's" tenure as Chairman and CEO of the enterprise, is there any evidence that he would deploy the proceeds from the sale of the New England properties in a manner that would thwart Mr. Murdoch's siege.

If the answer to the latter question is "no," then the Sulzberger family's argument (that they are the keepers of the flame of journalistic "integrity" and "excellence") disintegrates. You can't keep the flame burning if you don't have any fuel. You can't be a national and international newspaper if you don't have the means to support it. And from a fiduciary point of view, the Sulzbergers have to accept the fact that Mr. Murdoch's platform (News Corp.) enables him to lose money on the Wall Street Journal without any debilitating consequence. He really can bleed them to death.

What's in it for Google? Well, for one thing, it's cheap. Sell off the New England properties and the real cost is $3 billion. That's not much money to buy one of the premier brands of the information age. It also comes with some excellent real estate, which further reduces the risk. And happily enough, it will probably get cheaper in the coming months. So the price is definitely right.

Second, Google is embarking on an ambitious mobile platform. It is buying wireless spectrum and will soon introduce Google Mobile. In so doing, it is entering into an arena where the established players have hired (almost) every lobbyist and (almost) every law firm with expertise in telecommunications in Washington, DC and in virtually every state capital. Owning the New York Times would level that playing field in one fell swoop. Owning major media outlets is a strategy that has worked very well for General Electric, Disney, News Corp., Time Warner and others in their dealing with the federal government and with state governments. There's every reason to believe it would be helpful to Google.

Third, there's all that content. Google is a company that could actually make money repurposing the cultural and culinary coverage, to pick just two categories, of the New York Times, across both its Internet and mobile platforms. An acquisition of The New York Times would greatly enhance the richness and reach of Google News. And should Google choose to invest in expanded news and cultural coverage, it could greatly enhance the richness and reach of The New York Times.

Finally, a Google acquisition of the New York Times would allow Kleiner Perkins (which would likely be assigned the task of finding new management for the paper) to attract people of great talent to a fascinating and challenging project: the reinvention of a great newspaper across multiple platforms and within a variety of applications. Even if the project failed, the knowledge gained from the undertaking would make Google a better, smarter, more deft information age company.

The alternative, which is what the Sulzberger family must keep in mind at all times, is a slow, steady slide with a relentless and ruthless competitor attacking at every turn. Whatever else he does, "young Arthur" is not going to lead The New York Times to greater glory. He's had more than enough time to turn things around and no turn around has been forthcoming. Taking the company private will not work, because then the mission becomes debt service. The only real hope for the paper is what it could call a "strategic sale," on mutually agreed upon terms that would enable the Family to say it held up the flame.

John Ellis is a contributing columnist to RealClearPolitics.

Financials

The best way to invest in financials is to make a list of the companies you would like to own, and wait for the 2007 audited results. If your favorite financial companies still made a profit after all the writedowns, buy their shares. Auditors will be forcing companies to write down everything they can imagine. Don't worry about buying at historical lows because the object is to cut your risk level. When the smoke clears, investors are going to want to own the companies with managements who were not overly seduced by sub-prime debt.

Home Builders

Look at what happened to the stocks of mobile home manufactures after their bubble burst in the mid-1990's. Like stand-alone home buyers of recent years, anyone who could fog a mirror got a loan. The latter in mind, most people do not want to contemplate how long it will take for homebuilders to recover.

Still, there will be investors who understand the real value of the land homebuilders own, and who thanks to land values will not have their debt called by their creditors. These investors have a chance of making good money. Conversely, investors who are not willing to do dozens of hours of homework on the real value of property (while understanding better the debt covenants of corporate loans) should probably avoid homebuilders until the dust settles.

The second half of 2007 was surely painful for value investors, but excitement is rising about the values now being created by the panic of others. Take a deep breath, look past any downturn in the economy you may fear, and keep in mind that above average returns await investors who keep their risk low when buying beaten down stocks.

William L Dunn Jr. is a retired money manager. He can be reached at: valuebill@prodigy.net.

To witness the policy crack-up in Washington without any historical perspective is to assume the last thirty years did not happen; thirty years in which Keynesianism was largely discredited in favor of tax cuts, stable money, and laissez-faire economics. Investors are understandably scared because just as the world mostly followed our lead in the direction of free markets and low taxes, it could just as easily follow us back down the path toward more rigid economic management from the Commanding Heights.

Irrespective of their political affiliation, establishment economists continue to feed Washington’s heightened self-image when it comes to managing the economy. Fueled by editorials and studies suggesting the U.S. economy is merely experiencing a collapse in what elite thinkers term “aggregate demand,” politicians float all manner of temporary proposals meant to stimulate the near-term buying of “things.”

Forgotten here is the simple economic truth that our supply is our demand. We work and produce so that we can consume, and so rather than pushing redistributionist plans that in no way impact incentives to produce, Washington should be reducing penalties on production if it truly seeks to increase real economic activity.

From there, the answers are pretty simple. The 2003 tax cuts surely reduced penalties on work and investment. Those cuts are set to expire in 2010, but with stimulus in mind, should be made permanent. If Congress and the President think the economy needs something more, they should build on the aforementioned reductions with even greater marginal relief. Economies require work and investment in order to grow, so Washington should reduce the penalties on both.

Some say that due to the deliberate pace of legislation in Washington, major tax legislation would take too long to pass, and so short-term stimulus plans are the only answer for an economy needing relief now. That might be a realistic point if showering lower-income Americans with the dollars of others actually worked, but since it does not, the easy answer when it comes to timing stares us in the face.

Indeed, while tax cut legislation may take months to pass, an outline of what a future package might look like would not. To insure that Americans in no way delay increased economic activity with lower future rates in mind, Congress and the President should agree now that any tax cuts will be retroactive to January 1, 2008. A retroactive guarantee would give all productive Americans (and those on the sidelines too) assurance that growth-enhancing work will be taxed at the lower, more stimulative rates still to be determined.

Thanks to aggressive and at times more fitful moves toward incentive and market-driven economic policies over the last thirty years, the United States has provided a template for other countries to follow which has lead to a worldwide economic renaissance, and which has happily integrated economies the world over ever more tightly. Simply put, what our politicians do here matters both for our influence on non-U.S. economic policy, and for the size of our economy relative to the world’s integrated whole.

And so long as our political class embraces the discredited policies of decades past, investors will continue to shrug in ways that will make today’s perceived economic sluggishness seem tame by future comparison. If the economy really needs fuel to fix what our leaders deem a slowdown, then the time to cut marginal tax rates is now.

Certainly reduced capital costs sparked by the Fed funds cut is a positive development at the margin. But in a credit market where spreads between low risk Treasuries and corporate bonds are widening as a result of an increased reluctance to assume risk, the beneficial effect of the Fed lowering the Treasury curve via funds rate reductions may be somewhat diluted. This may explain why stock futures barely changed on net within one hour of the rate cut announcement, but also lends credence to the argument that another, highly positive variable was at work -- around the market open.

Certainly indexing capital gains for inflation would effect a positive change in the tax code, and would increase incentives to take investment risks. This is especially true with gold at $880/oz., compared to an approximately 12.5 year moving average of around $400. The former price is forecasting a 100 percent increase in the broad price level over the next 10 to 15 years.

Taking this further, if we Ignore the inaccuracies associated with the CPI or other statistical price measures, were the S&P 500 (with a current market capitalization of $11+ trillion) to double during the above timeframe, any executive order today to index these gains for inflation would mean that the future $11 trillion appreciation in the S&P would be tax free after inflation adjustments. In short, inflation indexing would constitute one of the largest tax cuts we've ever seen in dollar terms.

The "indexation news explanation" for yesterday's rally has significant implications for today's market action. There is no mention in this morning's major news outlets that discussions between President Bush, Majority Leader Reid and Speaker Pelosi included indexation. Even the Wall Street Journal's page A3 summary today by Hitt and Lueck fails to mention it. Has the idea been scrapped? Given the enormity and importance of the proposal, and the effect the rumor of its consideration may have had on stocks yesterday, this question itself threatens stocks today, and forecasts greater stock volatility ahead as news about Washington's fiscal stimulus plan - for better or worse - solidifies.

Retracement of 2003-2007 GDP Growth?

Those lower rates are also seen, correctly, as the prime mover in the economic recovery by the U. S. and the world after the financial crash of 2000-2002, and the Twin Towers attack of September 11, 2001. Take away those lower tax rates and the U. S. economy is unlikely to produce more jobs or output than was the case before the tax rates were adopted. Here is a graph of GDP growth since the 2003 tax cuts.

The markets do not relish the prospect of U. S. GDP retracing to its 2003 level, with all its implications for other global economies. Yet, as 2008 begins, the political outlook provides little reason to believe existing tax rates will be extended beyond 2010. Thus, the markets see major tax increases looming in the future, and the commensurate contraction in GDP.

Paulson “Czarship” Disappoints

No short term “fiscal stimulus package” of the nature being discussed by Congress and the White House will resolve this concern, because the relevant facts on the ground will remain essentially the same. A permanent cut in the corporate income tax rate would be beneficial in itself, but that would be a poor bargain for returning to higher rates on capital gains and dividends. Tax rebates and longer unemployment benefits relieve distress and reduce inventories in minimal ways, but do little to induce new investment or increased production. For one heralded as the coming economic “czar” when he came to Treasury from Wall Street, Secretary Paulson has displayed very little hardheaded leadership on such important issues.

Another Paulson shortcoming is complete destruction of Treasury credibility on dollar policy. He has repeated the Bush administration’s “strong dollar” policy even as the dollar’s value has dropped more sharply. Either Paulson prevaricates or he fails to implement his policy. The argument that the dollar’s value falls due to long term issues in the U. S. economy does not wash. The dollar’s value depends upon the amount of liquidity furnished by the Federal Reserve in relation to the level of demand for liquidity in productive investment. Surely the Fed and Paulson understand this, after the Fed drove the dollar’s value through the roof in 1997-1999 by withholding liquidity during economic growth. Monetary deflation produced by the Fed in those years caused prices (and profits) to collapse, making the 2000-2002 crash in U. S. equity shares inevitable.

From Severe Deflation to Severe Inflation

Since 2004, the Fed has done the opposite: slowing economic growth with higher costs of bank credit, while injecting too much liquidity for the ever-slowing economy to absorb. With too much liquidity and too little growth, the dollar’s value has plunged so that it now requires about $900 to buy an ounce of gold, whereas between 1988 and 2003 only $350 would buy the same ounce.

This is a concern of great import to every producer in the world who accepts dollar currency in exchange for production. Gold is an “ancient relic” relative to currency value only in the minds of abstract thinkers who wish to manage global economies in ways that dominate producers. Even if the U. S. economy were so powerful as to be able to impose such an economic regime on the world, doing so would be neither right nor wise.

Producers are entitled to receive and retain the value of their fair bargain. Currency manipulation to deprive producers of their bargain after the fact is unethical and immoral, not to mention a recognizable tool of trade war that provokes retaliation and mutual destruction. Keynesians who praise the Fed for devaluing the dollar to relieve the perceived current account deficit concern have not made the case for compromising the earning power of Americans.

Decisive Actions Needed by Fed and Congress

The Fed’s cut in the funds rate by three-quarters of a point on January 22 is beneficial, but is no more than another half-measure designed to preserve current monetary policy. If the Fed were to float the funds rate, as it should, allowing the markets to set the rate, the overnight loan rate for bank reserves would decline to a normal yield curve, probably below 2%. This would alleviate continuing credit dislocations, which the new funds rate of 3.5% will not because it remains higher than longer term yields. The dollar’s value can be strengthened and stabilized by managing liquidity to hit a gold price target, which ought to be done without further delay.

The tough reality for equity markets is that a good outcome for them requires significant beneficial actions on both U. S. monetary policy and fiscal policy. Congress controlled by Democrats historically unfriendly to making the 2003 tax cuts permanent must act responsibly and do so. Treasury and the Federal Reserve must reform monetary policy. Both challenges are daunting, and markets are facing those facts. ~

A base real rate of return, and additional compensation for inflation, taxes, and risks.

In order to focus on how tax policies affect the equity discount rate, let us assume that equity investors want a 4% base real rate of return and the required compensation for inflation and risk is expected to be 0%. Let us evaluate how the tax policies for the two competing presidential candidates affect the stock market. The Republican Candidate advocates maintaining a 15% tax rate on capital gains and dividends, while the Democrat Candidate advocates moving the rate to 35%. What is the affect of each of these policies on stock market values? First let us determine the equity discount rate under these circumstances.

Equity Discount Rate:

The increase in investor tax rates will increase the equity discount rate by more than 30%. To put this into perspective, let us value a hypothetical company that is expected to generate $100 a year of cash flow into perpetuity. Under these circumstances, the values of this company under the policies of Republican and Democrat Candidates are $2127 and $1613, respectively. (Please note that these calculations did not require a premium for inflation or risk. Incorporating these factors into the discount rate, only serves to increase the final return demanded by investors and further reduce market values and economic growth.)

The higher the taxes on investment returns, the higher the rate of return investors will require for their investments and the less they will pay for a given investment. A natural extension of this concept is that if the tax rate on investment returns increases, the value of those investments in the economy will decrease. In the context of the stock market, moving from lower investment tax rates to higher investment tax rates will lead to a drop in market values, all other things equal.

Unfortunately, that is not the end of the story. As tax rates go up and increase the equity cost of capital, by definition there will be fewer investment opportunities that meet this new, higher required investment rate. As a result, companies, and entrepreneurs will find fewer acceptable investment opportunities. This results in fewer investments throughout the economy and subsequently slower growth. This insight was part of the genius behind the Reagan Revolution, which lowered taxes and freed more capital throughout the economy to empower wealth creation and economic expansion. It is ironic, that by pursuing a “tax the rich” agenda, politicians inadvertently punish the middle class and the poor by reducing the opportunities for the economy to create better jobs and finance new business ideas that serve to economically empower those who need it the most.

So while this may sound good in theory, is there any proof that the markets react to such tax information? After all, markets go up and down every day, allowing anyone to read almost anything they want into such movements in the same manner that Mark Twain said, “figures lie and liars figure”.

But one particular event comes to mind. During the Bush-Kerry election in 2004, each candidate staked out opposite positions on capital gains taxes. President Bush argued that the current 15% rate should be maintained and made permanent, while Senator Kerry advocated raising them on the top 2% of wage earners. An interesting thing happened during that election, as at approximately 2:30 PM EST on November 2nd, flawed polling data leaked to the press indicated that Kerry would win Florida and the entire election. Prior to the false news leaking, the Dow had increased as much as 125 points, or about 1.2% during the day. Afterward the market proceeded to fall 150 points (about 1.5%) from its peak. In other words the prospect of higher taxes immediately motivated investors to sell assets. As clear as the message the market sent about higher taxes was, it sent an even stronger and clearer message about keeping taxes low. Over the next 2 days, the Dow rallied approximately 3% or 280 points signaling its relief that taxes would remain low and capital would likely continue to flow into investments.

America faces a similar choice in 2008. Virtually every Republican has vowed to keep capital gains taxes constant or to reduce them further, while every Democrat has vowed to work to restore capital gains taxes for all (or at least the wealthiest taxpayers) back into the low 30% range. Because polls continue to indicate that no party has a clear path to the White House, the market most likely has not discounted the effect of potential tax changes on stock prices. However, should one side gain a clear advantage, prepare to make appropriate strategic changes in the composition of your portfolio.

The first is that the federal government does not itself earn any money; it can only spend. Even though there are similarities to a “wind farm”, swinging arms in the sky and lots of hot air in circulation, this bicameral body generates no energy, nothing productive, by design. Those of us in the working world send a portion of the wealth we create to them. The idea behind the wealth transfer is to have the national government do things the people or the states can’t or shouldn’t do themselves, such as raising and maintaining the armed forces or supporting a judiciary. This process, of course, makes money easier for the government to obtain than it is for individuals and enterprises seeking capital.

The second part has to be that votes are the currency of politics, not the dollars the rest of us receive as compensation. Though political campaigns are nominally expensive, once a candidate is victorious, he or she has access to the resources collected by the Washington apparatus. This is the exact opposite of the way working people perceive their world; one that measures relative values in dollars: the best baseball players command the biggest paychecks for example.

These two add up to the realization that our elected representatives do not place as much importance on money and its value as we, the regular citizens, do. This has profound implications for the country and is nothing new, by the way. We should use this difference in incentives to understand the political-economic situation described above, as well as fiscal and monetary policy in general. The idea was well understood by the Americans who crafted the Constitution; a document that very much limited the reach of government. A market of free people could solve most “economic” problems on its own, especially with the strong protection of private property designed to give the people a real stake in market outcomes. Lest we forget, that was a radical concept in 1789.

For perspective, contrast the average guy’s income based upon skills in his field to that of a candidate who might have spent a million dollars to win a single vote, and with it the election (there have been oddball political situations like this, believe it or not). The politician would be seen as wasteful in the extreme by the private sector, quite smart in the public. Nevertheless, once in office, the successful candidate has access to all the funds, taxing power and patronage it controls. In this context, there is the obvious danger that congressmen, like other elected officials, may see money and its value as less important than votes. Since we are paid in dollars, this is often hard to understand outside of government, even though it explains a lot of strange Washington decisions made by people paid in votes.

In the end, it is up to the public to tell Congress it wants stable money and sound finances; not more empty promises on the subject based upon the way many on the Hill see money and taxes. They are often on the opposite side of the equation as spenders and consumers of tax revenue, while we are the ones producing their revenue. Think of the relationship as a mirror, with government reflecting society. Its revenue is our expense, and its surplus is our deficit. Remembering that as Congress discusses “short-term stimulus plans” might help us to advise our representatives more effectively.

For all his do-good preaching, Mr. Gates is ignoring the global spread of free-market capitalism that has successfully lifted hundreds of millions of people out of poverty and into the middle class over the last decade. Think China. Think India. Think Eastern Europe. (Maybe even think France under Sarkozy.) Mr. Gates wants business leaders to dedicate more time to fighting poverty. But the reality is that economic freedom is the best path to prosperity. Period.

The latest stats out of China are revealing. Here’s a country that was a basket case not so long ago and today is the world’s fourth largest economy — hot on the heels of Germany, the third largest economy. China just reported 11.2 percent fourth-quarter GDP, its fastest growth rate in thirteen years. Total output for China is now 24.7 trillion yuan, or $3.42 trillion at current exchange rates.

At $14 trillion, the U.S. economy is still four times the size of China’s. But we’ve had free-market capitalism for more than three-hundred years. China’s only had it for about fifteen. China is still an undemocratic, authoritarian, and repressive society that lacks the benefits of political freedom. But it was the late Milton Friedman who argued that the onset of free-market capitalism was the precursor to full-fledged democratic capitalism. China’s on the right track.

Mr. Gates says he has witnessed steep income and cultural inequities in his travels around the world, in particular to Africa. But for this he should blame the absence of capitalist principles, not capitalism itself. Even the most compassionate corporate executives are not going to bring prosperity to impoverished countries with statist economies. Until Africa’s nations undertake the market-oriented reforms that have boosted China and the other Asian Tigers — like South Korea and Taiwan — they will continue to rank at the bottom of the world prosperity scale.

The Heritage Foundation/Wall Street Journal 2008 Index of Economic Freedom reveals how free-market economics is spreading like wildfire while state-run socialism is on the decline. And it’s no wonder why. The free-market countries are prospering mightily while the least-free economies are mired in poverty. We’re talking North Korea, Cuba, Zimbabwe, and Iran. Also noteworthy is Venezuela. As the neo-socialist Hugo Chavez attempts to adopt Fidel Castro’s failed economic model, he’s sinking his nation toward Cuba-type poverty.

Economist Mark Perry, on his Carpe Diem blog site, reports that both the U.S. share of world GDP and its global stock market capitalization are shrinking. But this isn’t a bad thing at all. It doesn’t mean that America is heading downwards. On the contrary, it means that newly freed economies are heading up.

The reality here is that the rising tide of global capitalism is lifting all boats that employ it. Capitalism works. It’s a good thing. It’s the key to unlocking a nation’s prosperity. In fact, free-market capitalism is the greatest anti-poverty program ever devised by man.

Another billionaire, George Soros, the Davos partygoer who finances near every left-wing political-action group on both sides of the Atlantic pond, recently wrote in the Financial Times that the era of capitalism is coming to an end. Soros, of course, has been predicting this for at least twenty years — through the greatest world boom in history. And how was it that Soros made his money? Trading currencies in the technologically advanced world financial markets, the very same markets that were spawned by 20th century free-market capitalism.

So I just have to smile when billionaires like Bill Gates and George Soros turn cold shoulders to the blessings capitalism bestows. Or when their buddy, Warren Buffett, broadcasts the importance of hiking tax rates on successful earners and investors.

Look fellas, the command-and-control, state-run economics experiment was tried. It was called the Soviet Union. If you hadn’t noticed, it was a miserable failure.

— Larry Kudlow, NRO’s Economics Editor, is host of CNBC’s Kudlow & Company and author of the daily web blog, Kudlow’s Money Politic$.

Instead, capitalism is better than kind for engendering a form of ruthless benevolence whereby capital is constantly being directed away from the businesses and entrepreneurs who fail to give people what they want, and redirected toward those who are. With profit paramount in capitalist systems, capital rarely lies dormant such that its overseers can use it in ways inimical to the interests of the rich and poor alike.

When we consider living standards prior to the proliferation of the profit motive, a vastly different world existed. Economist Gregory Clark points out in his book A Farewell to Alms that before the onset of the Industrial Revolution, “the average person in the world of 1800 was no better off than the average person of 100,000 BC.” According to Clark, the “lucky denizens of wealthy societies such as eighteenth-century England or the Netherlands managed a material lifestyle equivalent to that of the Stone Age.”

Far from kind, pre-capitalist living among the masses took the form of what Clark terms “unrelenting drudgery,” with food in short supply, and early death a fact of life given the ravages of disease that capitalism hadn’t yet cured. Though humans today are capital themselves in the sense that a broad division of labor ensures greater work specialization and more plentiful output, death was a virtue in pre-capitalist societies thanks to the inability of its economic systems to produce much of anything for people very much in need.

Fast forward to the 19th century and industrialization, life for the average person changed substantially for the better. Whereas income had been flat for thousands of years, societies that welcomed the upheaval which industrialization brought saw their pay make near 180 degree turns upward.

And while capitalism surely created a class of wealthy owners, Clark notes that “industrialized economies saved their best gifts for the poorest.” To this day we see the truth in Clark’s words in that while the rich may have better houses, food and jobs than the average person, capitalism has done a better job than any other system of housing, feeding and employing those not at the top of the income pyramid.

Furthermore, Clark writes that when we look at how the rich live, “their current lifestyle predicts powerfully how we will all eventually live if economic growth continues.” Sure enough, this writer experienced the shock of seeing a wealthy Beverly Hills resident talking into a bulky hand-held cell phone in the mid-‘80s, but by the new millennium cell phones were ubiquitous; the only thing remarkable about them in recent years having to do with those not in possession of one.

Some, including Gates, might point to the wealth gap wrought by capitalism as a problem in and of itself, but returning to the proliferation of cell phones, capitalism is an engine that rewards profits; the profits frequently resulting from mass production of goods marketable to a broad spectrum of economic classes. So while some may bemoan the dollar-contrast between rich and poor, it’s that very contrast which continues to shrink the lifestyle gap between the rich and poor.

Gates speaks wistfully of a world in which companies would pursue profits while “improving the lives for those who don’t fully benefit from market forces.” But it’s there that he most impressively contradicts himself. There are parts of the world, particularly sub-Saharan Africa, that owing to a non-embrace of market forces have according to Clark produced “among the lowest material living standards ever experienced.”

Simply put, it’s a lack of market forces that has produced the poverty and ill-health that so vexes Gates. No doubt he would agree to a point, but in seeking a form of “soft” capitalism, he would to some degree retard the ruthless process whereby capitalism rewards those fulfilling individual needs, all the while punishing those that don’t.

In the end, “kind” when it comes to capitalism is a misnomer. Capitalism is about profits; the profits evidence of how unintentionally kind and virtuous capitalism actually is. That is so because it is profits that tell us who among the capitalist class is doing the most to remove uneasiness from the lives of others. To soften capitalism is to harden the lives of the poor.

It is an honor to join you here, and as Klaus has said, I have tried to get here several times before. I was determined to make it as Secretary of State and I guess I can say better late than never, Klaus. I spoke at the Forum by video in 2006, and I had the pleasure last year of receiving a group of Young Global Leaders at a first-ever U.S. Policy Summit. And so I understand that some of them are here today. It’s a wonderful legacy that you’re leaving, Klaus, in bringing these young people in.

I was thinking about what I was going to say tonight, and I’ve been watching the news and I’ve been looking at the images on television and I’ve reflected on the events of the day. And of course, what comes front and center for all of us is the turbulence – political and economic – in our world:

The violence in Kenya. The tragic assassination of Mrs. Benazir Bhutto in Pakistan. The ongoing and at times halting efforts of Iraqis and Afghans to build peaceful, functioning governments. The looming danger of climate change. The forecasts of market woes and economic troubles. Even a growing concern about globalization itself – a sense that increasingly it is something that is happening to us, not controlled by us.

As I took a look at all of this, I decided to do something risky: I want to talk about the importance of ideals and I want to talk about the need for optimism in their power.

Now, I know that whenever Americans start talking about idealism and optimism, international audiences groan. Perhaps there is a little concern that you’re going to hear a long, moralizing lecture. Well, I promise not to do that.

And another common concern when Americans talk of idealism and optimism is, “Well, there they go again,” the innocents abroad. Indeed, there is a long international tradition of viewing America as kind of young and naïve.

Well, in our defense, I would just say we’re not that young.

And if you are tempted to think that we are naïve, then you should hope that Bismarck was right when he said, “God has a special providence for fools, drunks, and the United States of America.” (Laughter.)

Seriously though, I recognize that there is a climate of anxiety in our world today. And it is tempting for many people to turn inward, to secure what they have, and to shut others out. Some want to go it alone. And there is certainly cynicism about the salience of our ideals when it seems that it’s just hard enough to protect our interests.

I know that many are worried by the recent fluctuations in U.S. financial markets, and by concerns about the U.S. economy. President Bush has announced an outline of a meaningful fiscal growth package that will boost consumer spending and support business investment this year. My colleague, Hank Paulson, who had hoped to be with you, is leading our Administration’s efforts and working closely with the leaders of both parties in Congress to agree on a stimulus package that is swift, robust, broad-based, and temporary.

The U.S. economy is resilient, its structure is sound, and its long-term economic fundamentals are healthy. The United States continues to welcome foreign investment and free trade. And the economy, our economy, will remain a leading engine of global economic growth. So we should have confidence in the underlying strength of the global economy – and act with confidence on the basis of principles that lead to success in this world.

And on that note, I would submit to you this evening that there is not one challenge in the world today that will get better if we approach it without confidence in the appeal and effectiveness of our ideals – political and economic freedom, open markets and free trade, human dignity and human rights, equal opportunity and the rule of law. Without these principles, backed by all forms of national power, we may be able to manage global problems for awhile, but we will not lay a foundation to solve them.

This is the core of America’s approach to the world. We do not accept a firm distinction between our national interests and our universal ideals, and we seek to marry our power and our principles together to achieve great and enduring progress. This American approach to the world did not begin with President Bush. Indeed, it is as old as America itself. I have referred to this tradition as American Realism.

It was American Realism that enabled the United States to come into being in the first place. It was American Realism that led us to rally our allies to build a balance of power that favored freedom in the last century. And in this century, it is this American Realism that shapes our global leadership in three critical areas that I’d like to talk about tonight: the promotion of a just economic model of development; the promotion of a freer, more democratic world; and the role of diplomacy in overcoming differences between nations.

First, let us take development. Amidst the extraordinary opportunities of the global economy, which we will talk about here, the amount of deprivation in our world still remains unacceptable. Half of our fellow human beings live on less than $2 a day. That’s simply not acceptable in a civilized world. But as we approach the challenges of development, let us remember that we know what works: We know that when states embrace free markets and free trade, govern justly and invest in their people, they can create prosperity and then translate it into social justice for all their citizens.

Yes, some states are growing economically through a kind of “authoritarian capitalism.” But it is at least an open question whether it is sustainable for a government to respect people’s talents but not their rights. In the long run, democracy, development, and social justice must go hand in hand.

We must treat developing nations not as objects of our policy, but as equal partners in a shared endeavor of dignity. We must support leaders and citizens in developing nations who are transforming the character of their countries – through good governance and economic reform, investment in health and education, the rule of law and a fight against corruption. And we must transform our foreign assistance into an incentive for developing nations to embrace political and economic liberty, to build just and effective states and to take ownership of their own development.

In recent years, the United States has been trying to put these principles into practice in our core development policies. Indeed, under President Bush, and with the full support of our Congress, the United States has launched the largest international development effort since the Marshall Plan.

We have met or are clearly on course to meet all of our international commitments to increase official development assistance: Since 2001, we have doubled our assistance to Latin America, we’ve quadrupled it for Africa, and we’ve tripled it worldwide, all while reforming it to better support responsible policies of developing states.

We have put $7.5 billion into our Millennium Challenge Account initiative, which is rooted in the ideals of the Monterrey Consensus. We have also launched historic efforts to combat malaria and HIV/AIDS. In fact, President Bush’s Emergency Plan for AIDS Relief is the largest effort ever by one nation to combat a single disease.

But more and better aid has to be accompanied by the global expansion of free and fair trade. It isn’t easy – I will tell you, it is not easy -- for the American president to advocate free and fair trade at a time of growing economic populism. Yet President Bush remains committed to completing a successful Doha Round, and my colleague Susan Schwab, who is here tonight in Davos, is working hard to do just that.

The President has pledged that the United States will eliminate all tariffs, subsidies, and barriers to free flow of goods and services – including agriculture – as other nations do the same. We expect our partners to join us in finding a way to make Doha a success.

If we are to continue expanding global economic growth, we also need to find a new approach to energy and the environment. If we proceed on our current course, we have an unacceptable choice: Either sacrifice global economic growth for the health of our planet – or sacrifice the health of our planet for fossil fuel-led growth. We cannot do that. We have to reject this course – and work instead to cut the Gordian Knot of fossil fuels, carbon emissions, and economic activity.

I want to assure you that we Americans realize how central a solution to climate change is to the future health and success of the international system. And we will be tireless in helping to lead the search for that solution: through the UN Framework Convention and through the Major Economies Meetings that President Bush proposed, the first of which we hosted this past September.

As we work for a more just economic order, we must also work to promote a freer and more democratic world – a world that will one day include a democratic Cuba, a democratic Burma, and a fully democratic Middle East.

Now, this emphasis on democracy in the Middle East is controversial, I admit, and some would say, “Well, we’ve actually made the situation worse.”

I would ask: Worse compared to what?

Worse than when the Syrian army occupied Lebanon for nearly 30 years? Worse than when the Palestinian people could not hold their leaders accountable, and watched as a chance for peace was squandered and evaporated into the second intifada?

Worse than the tyranny of Saddam Hussein at the heart of the Middle East, who terrified his neighbors and whose legacy is the bodies of 300,000 innocent people that he left in unmarked mass graves?

Or worse perhaps than the false stability which masked a freedom gap, spawned hopelessness, and fed hatreds so deep that 19 men found cause to fly airplanes into American cities on a fine September morning?

No, ladies and gentlemen, the past order in the Middle East is nothing to extol, but it does not make the challenges of the present less difficult. Even when you cherish democratic ideals, it is never easy to turn them into effective democratic institutions. This process will take decades, and it will be driven, as it should be, and as it only can be, by courageous leaders and citizens in the region.

Different nations will find ways to express democratic values that reflect their own cultures and their own ways of life. And yet the basics are universal and we know them – that men and women have the right to choose those who will govern them, to speak their minds, to worship freely, and to find protection from the arbitrary power of the state.

The main problem for democracy in the Middle East has not been that people are not ready for it. The problem is that there are violent forces of reaction that cannot be allowed to triumph.

The problem is that too many Lebanese journalists and parliamentarians are being assassinated in a campaign of intimidation, and that the Lebanese have not been permitted to elect their president freely.

The problem is that too many peaceful human rights activists, and journalists, and bloggers are sitting in prison for actions that should not be considered crimes in any country.

The problem is not that a group like Hamas won one free election; it is that the leaders of Hamas still refuse to make the fundamental choice that is required for any democracy to function: You can be a political party, or you can be a terrorist group, you cannot be both.

We should be under no illusions that the challenges in the Middle East will get any better if we approach them in a less principled fashion. In fact, the only truly effective solutions to many of these challenges will emerge not in spite of democracy, but because of it.

Democracy is the most realistic way for diverse peoples to resolve their differences, and share power, and heal social divisions without violence or repression.

Democracy is the most likely way to ensure that women have an equal place in society and an equal right to make the basic choices that define their lives.

And democracy is the most realistic path to lasting peace among nations. In the short run, there will surely be struggles and setbacks. There will be stumble and even falls. But delaying the start of the democratic enterprise will only mask tensions and breed frustrations that will not be suppressed forever.

Now this brings us, finally, to the matter of diplomacy. Do optimism and idealism play a role in this endeavor, which is by its very nature the art of the possible? Is it as Lord Palmerston said – that “nations have no permanent enemies and no permanent allies, only permanent interests?”

Well, I can assure you that America has no permanent enemies, because we harbor no permanent hatreds. The United States is sometimes thought of as a nation that perhaps does not dwell enough on its own history. To that, I say: Good for us. Because too much focus on history can become a prison for nations.

Diplomacy, if properly practiced, is not just talking for the sake of talking. It requires incentives and disincentives to make the choice clear to those with whom you are dealing that you will change your behavior if they are willing to change theirs. Diplomacy can make possible a world in which old enemies can become, if not friends, then no longer adversaries.

Consider the case of Libya. Just a few years ago, the United States and Libya were locked in a state of hostility. But as Libya has chosen to reject terrorism, to renounce its pursuit of weapons of mass destruction, and to rejoin the international community, the United States has reached out, and today, though we still have our differences, we have nothing to fear from one another.

The United States is building a similarly positive relationship with Vietnam, which would have been unthinkable 30 years ago – and of course with China, we have built a productive relationship that redounds to the benefits of both our peoples.

But perhaps nowhere is it clearer that we have no permanent enemies than in our relationship with Russia. Ladies and gentlemen, the recent talk about a new Cold War is hyperbolic nonsense. Our relations today are fundamentally different than they were when all we shared was the desire to avoid mutual annihilation.

The fact is that the United States and Russia are working constructively today on many issues of mutual interest – from counter-proliferation, to counter-terrorism, to the pursuit of peace in the Middle East. And we are determined to remember this, even when we hear unwise and irresponsible rhetoric from Russia itself that harkens back to an earlier time.

To be sure, there have been disappointments. Though we recognize that Russians today enjoy considerable personal and economic freedom, we believe that Russia’s greatness will ultimately be secured best through greater political freedom for its people – and through the establishment of strong institutions that check the power of the state, rather than serve the interests of a few.

We also believe that Russia should contribute to a transparent and open global energy economy, not a monopolistic one. But whatever the difficulties, no one can imagine a world in which the absence of U.S.-Russian cooperation will make any of our challenges easier to solve.

It is because America desires no permanent enemies that we can imagine a better relationship with North Korea, and we are working to build it through the Six Party Talks. North Korea is disabling its Yongbyon nuclear facility, but there are other obligations that have yet to be met and must be, including the provision of a complete and accurate declaration of all nuclear programs and activities.

Still, we continue to believe that we can use the Six Party Talks for even larger purposes: to finally end the conflict on the Korean Peninsula; to forge a mechanism for security cooperation in Northeast Asia; to make peninsular issues a source of regional cooperation, not conflict; and to improve relations between North Korea and the international community, which would benefit no one more than the North Korean people themselves.

Let me assure you that the United States also has no desire to have a permanent enemy in Iran, even after 29 years of difficult history. Iranians are a proud people with a great culture, and we respect the contributions that they have made to world civilization. We have no conflict with Iran’s people, but we have real differences with Iran’s government – from its support for terrorism, to its destabilizing policies in Iraq, to its pursuit of technologies that could lead to a nuclear weapon.

With our agreement yesterday to pass a third Chapter 7 sanctions resolution, the permanent members of the Security Council plus Germany showed that we remain united, that we do not want Iran to become a nuclear weapons power, and that we will continue to hold Iran to its international obligations.

Ultimately, though, this problem can and should be resolved through diplomacy. Should Iran suspend its uranium enrichment and reprocessing activities – which is an international demand, not an American one – we could begin negotiations, and we could work over time to build a new, more normal relationship – one defined not by fear and mistrust, but growing cooperation, expanding trade and exchange, and the peaceful management of our differences.

Our confidence that there are no permanent enemies also gives us hope that two states, Israel and Palestine, will one day live side by side in peace and security. The Annapolis process will support the bilateral efforts of Prime Minister Olmert and President Abbas to end the conflict between their peoples. But we must not lose sight of what that peace will really mean.

Peace will mean that Palestinians will never again suffer the humiliations of occupation and wasted hours spent in checkpoints – and will instead be free to work and prosper in a state of their own. Peace will mean that Israelis who have so justly and proudly defended the Jewish state for the past 60 years will finally see their right to exist affirmed and accepted by their neighbors. And peace will mean that the hatreds borne of this now 60 year-old conflict will pass away with this current generation, not be passed on to infect new ones.

All conflicts must end, and nations need not have permanent enemies. But Lord Palmerston was wrong on the other part of his quote – that nations have no permanent allies. The United States has permanent allies: They are the allies with whom we share values – allies like Japan, and South Korea, and Australia, the allies we have in our own hemisphere, and of course, the allies we have across this continent – within NATO and the European Union.

Let me speak for a moment about this extraordinary alliance called the transatlantic alliance. The United States expects a lot of our allies. And our allies expect a lot of us. And the alliance has endured recent frictions, but it has never fractured. And the transatlantic alliance is defined today not by the differences between us, but by the work we do together to support the global success of our shared ideas – most importantly in Afghanistan.

I recognize that this is not easy work. We have all struggled to master the challenge of counterinsurgency– of marrying our civilian reconstruction and development efforts with our military operations. NATO is not performing perfectly. Neither is America. And our publics need to be told honestly that we are engaged in a real war in Afghanistan, that there will be sacrifices, that this is not just a peacekeeping operation, and that the stakes could not be higher for the Afghan people, for our alliance, and for international security.

But for all of the challenges NATO is facing, let us remember how far we have come. I remember when NATO saw the world in two parts: There was Europe, and then there was “out of area” – which was pretty much everything else. So who could have imagined seven years ago that our alliance today would be training troops in Iraq, providing air lift in Darfur, and rooting out terrorists in places like Kandahar? These are increasingly the challenges of the 21st century, and I am optimistic that NATO will meet them, just as it met the challenges of last century.

It is true, ladies and gentlemen, that optimism and confidence in our ideals are perhaps a part of the American character, and I admit that this can make us a somewhat impatient nation. Though we realize that our ideals and our interests may be in tension in the short term, and that they are surely tested by the complexities of the real world, we know that they tend to be in harmony when we take the long view.

Like any nation, we have made mistakes throughout our history, and we are going to make them again. But our confidence in our principles, and our impatience with the pace of change, is also a source of our greatest successes – and this will ensure that the United States remains a strong, confident, and capable global leader in the 21st century.

Yes, our ideals and our optimism make Americans impatient, but our history, our experience, should make us patient at the same time. We, of all people, realize how long and difficult the path of democracy really is. After all, when our Founding Fathers said “We the People,” they did not mean me. It took the Great Emancipator, Abraham Lincoln, to overcome the compromise in our Constitution that made the founding of the United States of America possible, but that made my ancestors three-fifths of a man.

So we Americans have no reason for false pride and every reason for humility. And we believe that human imperfection makes democracy more important, and all who are striving for it more deserving of patience and support. History provides so many affirming examples of this.

After all, who would have thought that Japan would be a pillar of democratic stability in Asia? Once, that seemed impossible. Now, it seems inevitable.

Who would have thought that Germany and France would never go to war again and would instead join in union? Once, that too seemed impossible. Now, it too seems inevitable.

And who would have thought that NATO and the European Union would erase old divisions of East and West, that they would unite democratic nations across Europe, and that the Alliance would hold its 2006 Summit in Latvia? Once, that seemed impossible. Now, it too seems inevitable.

And even today, from time to time, we catch the occasional glimpse of what a better world could look like. I have seen it while sitting in a provincial council in Kirkuk, and watching as Iraqis search in peace for ways to resolve their differences. I have seen it when I watched the Saudi Foreign Minster applaud the Israeli Prime Minister’s speech about a new opportunity for peace.

And I have seen what a better future could look like when, improbably, I have watched the American president stand with elected leaders under the flags of a democratic Iraq, a democratic Afghanistan, and the democratic future state of Palestine.

That ultimately is the role of confidence in the eventual triumph of our ideals: to face the world everyday as it is, but to know that it does not have to be that way – and to keep in sight the better, not perfect, but better world that it can be.

Thank you very much.

No more. In recent months, the noisiest criticism of the Fed has come from Wall Street. Hordes of money managers, commentators and economists have joined Cramer in ridiculing Bernanke and other Fed officials. They're "clueless" and "behind the curve." The blunt message: Cut interest rates; revive the economy; boost stock prices. But these custodians of capital no longer speak only for small numbers of the superwealthy. From 1980 to 2005, the share of U.S. households owning stocks or mutual funds went from less than 19 percent to 50 percent.

Just as the late-19th-century populists, mostly farmers, wanted the government to provide cheap money and curb the railroads' power, today's financial populists think government should somehow guarantee that the economy always expands and that stock prices always rise. Whenever either seems threatened, there's a clamor for action. Last week, Bernanke's Fed seemed to capitulate by cutting its overnight Fed funds rate from 4.25 percent to 3.5 percent (as recently as mid-September, it had been 5.25 percent). Another cut could come this week.

Of course, the Fed doesn't think it was surrendering to critics. Instead, it was trying to avert a financial stampede. Before the Fed took action, global stock markets were plunging; they were already down 12 percent for the year, says Howard Silverblatt of Standard & Poor's. The paper loss totaled $6 trillion. There were signs of a huge sell-off of U.S. stocks. The Fed rate cut aimed to prevent a panic that would feed on itself. Lower rates would improve confidence by cushioning any economic slowdown.

Fair enough. The trouble is that this may be a distinction without a difference, because market sentiment -- what sends prices up or down -- is heavily shaped by the financial populists operating through the business cable channels, Internet-distributed commentaries and the print press. There is a vast echo chamber in which if something is repeated often enough, it becomes its own reality. When there's mostly cheering, stock or bond prices rise; with boos, prices fall. Either way, the Fed must deal with what "the markets" are saying. The present panicky climate results, at least partly, from all the invective heaped on the Fed.

What Cramer and many talking heads offer are selective and sensationalized views that favor short-term conditions and immediate gratification: higher stock prices tomorrow; better trading profits. By these appraisals, the U.S. economy is in dire shape. Who knows? Maybe a calamity lies just ahead. But as yet, the evidence is unconvincing. For all of 2007, profits of nonfinancial corporations were up 6 percent, says Silverblatt.

Of course, the economy has serious problems. But not every problem -- even a recession -- is the apocalypse. In the late 1990s, the electronic echo chamber promoted unrealistic euphoria that fed the "tech bubble." It's not just that these portrayals, in both directions, exaggerate. They may also encourage self-defeating economic policies.

The Fed's first responsibility is to keep inflation at low levels because, without that, its other goals of maximum economic growth and low unemployment become impossible. We learned this lesson painfully in the 1960s and the 1970s. Political pressures then to avoid all recessions led the Fed to relax money and credit too often. The perverse results were higher inflation and more frequent and harsher recessions. Annual inflation peaked at 13.3 percent in 1979 and annual unemployment at 9.7 percent in 1982.

Some economists think that the Fed is already repeating its previous error, now prodded by "market pressures" and the specter of financial panic. If the market constantly demands to be stimulated by lower interest rates and easier credit, and threatens to go into an uncontrolled tailspin if it isn't, then the Fed is in a treacherous position. Trying to make matters better now may make them much worse in a few years if higher inflation emerges. This danger is easily overlooked.

Two years later stock markets and the economy are as mentioned uncertain, and contrary to assumptions from the past suggesting he was open to classical ideas, his public utterances since then have shown him to be every bit the conventional academic so many investors hoped he was not. Perhaps owing to the latter, investors are disappointed, but they should not be surprised. Bernanke is merely acting on long-held beliefs about monetary policy and the economy; beliefs that he made apparent right up to his nomination.

For anyone who’s read the various post-meeting FOMC press releases since Bernanke took over, there’s been a consistent theme in nearly every one. Rather than defining inflation as something monetary in nature, the Bernanke Fed has reverted to Phillips Curve logic suggesting it results from too much economic growth and too many people working. In Bernanke-speak, “high levels of resource utilization have the potential to sustain inflationary pressures.”

Owing to Bernanke’s view that growth is the cause, not the cure for inflation, he’s persisted in his adherence to Keynesian rate targeting rather than floating the Fed funds rate in favor of a dollar-price target. But it would be unfair to say Bernanke duped anyone when it came to his views on the causes of inflation. Indeed, in an August 2005 Wall Street Journal op-ed, he asserted that there is a “highest level of employment that can be sustained without creating inflationary pressure.” Despite a gold price that had risen well above its 10-year average during the time in question, the inflationary evidence revealed by the dollar’s fall was never mentioned.

Moving to taxes, supply-siders were understandably unhappy with the way in which Bernanke endorsed President Bush’s economic stimulus package. They were because in the grand Keynesian tradition of demand-side “stimulus,” Bernanke called for fiscal measures so long as they were “explicitly temporary.” Hardly the musings of a supply-sider, but then Bernanke had already made plain his Keynesian orientation when it came to taxes in the aforementioned Journal op-ed. According to him, the “fiscal stimulus” that resulted from the 2003 Bush tax cuts had diminished “in the past few quarters.”

During his November 2005 confirmation hearings, Bernanke certainly mentioned gold as an inflation indicator he would look at among others, but his belief that adherence to the gold standard caused the Great Depression is also well known. In a 2002 speech Bernanke told the late Milton Friedman, “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

If uncertainty remains as to Bernanke’s true views when it comes to gold’s inflation-signaling power, he answered those questions last week with the release of the FOMC statement announcing the latest round of interest rate cuts. With the yellow metal at all-time highs, the statement said, “The Committee expects inflation to moderate in coming quarters.” A stronger non-endorsement of the gold signal would be hard to find. Mainstream accounts in the aftermath of the cuts suggested further dollar weakness resulted from those same cuts, but it says here the bigger factor at play was a statement suggesting there’s no link between currency weakness and inflation.

With the Fed Chairman seemingly oblivious to how the dollar’s weakness and instability retard economic activity worldwide, traders continue to sell it lower with full knowledge that irrespective of the nominal level of interest rates, Bernanke has taken his eye off the ball. Simply put, the dollar’s value is being ignored by the Fed and Treasury, so its value continues to plummet.

Some might say we should be surprised by the state of things, but that’s unfair. Bernanke gave fair warning of who he was long before his nomination. Instead, blame lies with a Bush Administration that failed to do its homework on Alan Greenspan’s replacement. And with that same administration lacking any dollar policy other than one of “benign neglect,” it has essentially outsourced its policy to Ben Bernanke, a Fed Chairman whose seeming countenance of dollar weakness weighs on the Administration’s approval ratings like no other policy today.

“Fixed exchange rates are obsolete,” declared Zhou en-Wang, a spokesman for China’s Central Bank. “We have revalued the yuan, which was fixed against the dollar for only eight years. The American inch has been fixed for 49 years. It is time for a change.”

The surprise Chinese announcement sent a ripple of panic through the U.S. real estate industry. Shares in title insurance companies fell sharply on fears that a revaluation of the inch could affect the ownership of every piece of property in the U.S. “Lot boundaries are specified in terms of feet, and the foot is based upon the inch,” said John Landy, speaking for the American Board of Realtors. “A change in the value of the inch would cause chaos.”

Speaking on background, a senior Bush administration official noted that the source of the conflict was growth rates. “The Chinese economy has been growing much faster than the U.S. economy,” he said. “This is why we have been pushing them to revalue the yuan. On the other hand, in terms of height, Americans have been growing faster than the Chinese. Revaluing the inch would address this imbalance.”

The U.S. inch has been fixed at 25.4 millimeters since 1958. While the Chinese have stated officially that the length of the inch should be determined by “market forces”, high-ranking officials of the Beijing government hinted that China was looking for an immediate 3.4% revaluation, which would increase the length of the inch to 26.3 millimeters.

A Question of Competitiveness

The administration official noted, “What they want is pretty simple. The average American adult male is five feet, nine and one quarter inches tall. The average Chinese adult male is 1700 millimeters tall, which is five feet, seven inches at the current exchange rate. You do the math.” He added that, while “America will not be dictated to,” the government was taking the Chinese demand seriously. “Realistically, there is no other way to equilibrate the height of the people of the two countries,” he said.

Psychologically, the stakes are huge. Height is a major social issue in China, with some Chinese resorting to extreme measures, such as slow, agonizing, thigh-bone-lengthening surgical procedures, to make themselves taller. Revaluation of the inch would make the average Chinese as tall as the average American, thus diminishing height concerns as a source of societal unrest. This is not an insignificant issue for China's Communist government, which is deeply concerned about social stability in the huge, rapidly transforming nation.

Is Revaluation the Answer?

John Kenneth Samuelson, an economics professor at Harvard, agreed that fixed exchange rates are an anachronism. “The U.S. floated the dollar in 1971,” he said. “It’s high time that we floated all of our other units of measure.” While conceding that uncoupling the dollar from its fixed definition in terms of gold led to skyrocketing inflation, sky-high interest rates, escalating unemployment and decades of sub-par economic growth, the professor argued, “Floating exchange rates work better in theory, and this is what counts.” He added, “Merely devaluing the inch to a new fixed exchange rate against the millimeter isn’t enough. We need true floating exchange rates, with the magnitude of all of our units set by the market. What makes the Bureau of Standards think that they know the best length for the inch or weight for the pound?”

Strong opposition to any revaluation of the inch surfaced almost immediately in industries that would be affected. Christine Love, CEO of the publicly-held dating service Realistic Expectations, condemned the idea. “Most of our female clients want a man who is at least six feet tall,” she noted. “Men of this height are in short supply now. Revaluing the inch would only make things worse.”

Health Concerns Loom Large

Americans are growing fatter and excess weight has been linked to many health problems, including diabetes, heart disease, and cancer. A measure called the Body Mass Index (BMI) is the government’s principle tool for tracking the problem. People with a BMI of more than 25 are considered overweight. A BMI of 30 is considered the threshold of obesity, with people with BMIs above 40 designated “morbidly obese”.

“Devaluating the inch by 3.4 percent would increase the BMI of every American by almost seven percent,” said Dr. Marcus Casey, speaking for the American Medical Association. “The impact on the incidence of obesity would be catastrophic.” He added, “If anything, we should be looking at reducing the length of the inch. This is the only way we can reduce Americans’ BMIs quickly and start getting a handle on obesity-related mortality and morbidity.”

Asked to comment on the AMA statement, economics professor John Kenneth Samuelson scoffed. “That is ridiculous,” he said. “All we would have to do is to revalue the pound at the same time we revalued the inch.” He added, “Now, I’m not recommending this. As I said before, I believe that the inch and the pound should float freely against the millimeter and the kilogram in the market.”

What next?

The administration is studying the Chinese demand. “The Chinese only revalued the yuan by 2.1 percent at first,” commented a highly placed source. “What right have they got to demand that we revalue the inch by 3.4 percent overnight?” Still, he conceded that, “It’s a real issue. Some kind of compromise is likely.”

Asked to comment on the “inch crisis”, Billy Bob Couxrouge, a tow-truck driver from Beaumont, Texas, said, “I don’t get it. How can changing the inch change how tall I am?”

By grounding the discussion of fiscal policy to the Nikkei's performance, the LDP is elevating the market as the ultimate test of policy merit, which is a very helpful way of orienting the policy debate. Indeed, this may be the only way to get Japanese policymaking out of the thrall of zero-sum thinking -- where every tax cut must be offset by a tax increase or a spending cut --and into a more dynamic setting, where it is understood that faster economic growth and increased production often mean increased tax revenues.

This does not mean that the LDP has suddenly embraced the supply-side doctrine of the Laffer Curve, but latest indications are that some of these policymakers may be picking up the scent and heading down the trail. Among the most interesting proposals being reported by Bloomberg is the recommendation to abolish the taxation of capital gains and dividends. LDP legislators would like such an exemption to be in place temporarily, that is, until the Nikkei reaches 18,000. But they would like to expand existing exemption levels -- Y5million for capital gains and Y1million for dividends -- permanently. Similar to President Bush’s 2003 tax cuts, which temporarily reduced taxation on capital gains and dividends and thus helped the U.S. economy out of the post-9/11 economic downturn, the LDP’s suggestions could have a similar salubrious effect and breathe new life into the Nikkei, reinvigorate the economy and reverse the LDP’s political decline.

Were such an idea to pass, we could imagine the LDP's own attitude toward taxation evolving for the better; embracing the Tax Cutting Santa role as the Nikkei advanced and government revenues increased. Who knows, initial policy success might even mature to permanency. Such a scenario is only wishful thinking at this point. But it should not be ignored that some LDP policymakers, having suffered through the unprecedented loss of the Upper House during the 2007 elections, seem to be waking up to the realities of a more competitive political environment.

Today, the Democratic Party of Japan (DPJ), which holds control of Japan’s Upper House, seems poised to capitalize on the LDP’s sagging popularity and policy missteps. For example, the LDP is currently taking flak for its proposal to raise the gasoline tax for ten years, even as gas prices have risen in tandem with a yen that continues to weaken against oil, gold and other commodities. The unpopular proposal, opposed by the DPJ, is being pushed by the fiscal conservatives of the LDP to help close Japan’s $200+ billion budget gap. But more fiscal conservatism will not revive Japan’s moribund market nor is it likely to rev up sub-par economic growth.

This is why the tax exemption proposals on capital gains and dividends are so exciting. They represent the beginnings of a potential revolt against the party's fiscal conservatives, whose commitment to fiscal austerity is sending the party on the path to oblivion. Indeed, tax policy has been a growing weakness for the LDP. In the last half of 2007, the most significant proposal offered by the LDP-backed government was basically a zero-sum proposition centered around lowering Japan's corporate tax rate in exchange for a consumption tax hike to 10% from 5. According to PricewaterhouseCoopers the official corporate tax rate is 30%, but combined with local taxes the effective tax can be as high as 50%. The consumption tax increase proposal is a noxious idea, which has been kicked down the road by successive Prime Ministers since Junichiro Koizumi.

What's more, the proposal failed to address significant upcoming tax changes that are likely weighing on investors’ minds, such as the expiration of temporary tax cuts on capital gains and dividends, which would effectively raise rates to 20% from 10% by December 2008 and March 2009, respectively. How can the Nikkei mount any sort of sustained rally when taxes on capital gains are set to double? How would this permit the economy to grow more briskly?

To be sure, the Nikkei's current woes are not entirely derived from its hapless fiscal bind. After all, the market, like the S&P 500, is being affected by inflationary monetary policy (the yen) and ongoing troubles in international credit markets. But we applaud the group within the LDP that understands what is good for the Nikkei may also be good for Japan. And their willingness to seek market-friendly policies should be interpreted as a step in the right direction.

Although they may face stiff resistance from the LDP's diehard fiscal conservatives, we hope that the LDP faction now on the hunt for more market friendly policy proposals ultimately prevails. Even better would be for Japanese policymakers to abandon their attachment to zero-sum thinking -- which has exclusively fixated on closing budget shortfalls -- and look for ways to increase Japanese productivity and economic growth.

One of the best ways would be to increase the amount of capital relative to Japanese labor by permanently eliminating the taxation of capital gains altogether. Even if LDP lawmakers did so temporarily -- say 10 years to make up for Japan's lost decade of the 90s -- the resulting boost for the market and economy would improve Japan's fiscal situation and likely restore the LDP's dwindling political heft.

To the trade-deficit worriers in our midst, the individual freedom we’re all afforded to purchase what we want while ignoring country origin foretells a dark future owing to our propensity to buy things not produced within these borders. The infinite individual decisions that constitute total U.S. consumption have for centuries put our trade balance in deficit, and according to various “wise” thinkers, we as a nation will eventually pay dearly for having always exercised this basic freedom.

What’s never been explained is how we as a nation continue to grow and prosper despite consuming in ways that are supposedly inimical to our economic health. Better yet, no one has told us how U.S. equity markets have gone skyward over the past twenty-five years despite an explosion in those allegedly awful deficits. With trade-deficit scaremongers embodying the old saying that “tomorrow is the day that will never come,” those not in thrall to mercantilist dogma are left to believe investors are so obtuse as to continue to bid up shares in a country whose economy is supposedly headed for a crack-up.

So why exactly is it that trade deficits have never mattered to investors, and why is it that they never will? The answer is a simple one, and the ugly gyrations of world equity markets over the past few weeks have provided it. Rather than a “decoupled” group of countries more and more dependent on economic activity within country borders, we’re very much a “coupled” collection of countries whereby the activities of the worldwide labor force are increasingly integrated. As such, economic malaise in one link of the integrated chain holds repercussions for everyone else.

When it comes to trade, just as we would never bother to consider the trade deficit San Francisco has with Detroit, in the same way we should pay no mind to any “deficits” of trade held with Shanghai. The goods we import from the rest of the world are the reward we get for being so productive ourselves.

Thanks to an integrated worldwide labor force, we as individual Americans purchase goods with no regard to country origin so that we can achieve our own comparative advantage. Simply put, we outsource to others the manufacture of our shoes, socks and televisions so that we have more time to build the Googles, Microsofts and Amazons that make our economy the envy of our trading partners. The trade ultimately balances in that we buy from the rest of the world what’s not in our economic interest to produce, and we pay for our consumption through the export of shares in our even more productive endeavors.

Despite this wealth-enhancing trade arrangement, economists and journalists continue to cheer when less in the way of “foreign” goods reach our shores. Any excitement is misguided. If not for others making for us what we don’t need to make, the finite amount of human capital we have within these borders would have to spend more time engaging in the kind of activity that markets value less.

Returning to present market uncertainty, the economic challenges we face thanks to less than optimal monetary policy are challenges an increasingly integrated world economy faces. If we’re suffering here, our trading partners feel it. And if economic problems overseas harm their ability to produce for us, we’ll feel it too in the form of lower productivity.

In his otherwise unremarkable autobiography, The Age of Turbulence, Alan Greenspan noted that the world’s "current account balance is zero." World stock markets apparently agree. The trade deficits countries run with each don't matter at all considering our integrated whole, but when one country is sick, the illness spreads.

Ongoing credit stresses in economies around the world can be traced back to central banks – primarily the Federal Reserve – that have manipulated bank credit costs by creating an inverted yield curve. The inverted yield curve is a serious anomaly that free markets would not permit; yet the Fed presumes it can be imposed on the markets without significant impacts. In this instance, as always, market participants act to their advantage according to perceived conditions. When the cost of bank credit it pushed higher than the markets determine is reasonable, bank credit is effectively denied, and economic activity markets would ordinarily engage in is prevented. This is economically harmful action by the central bank.

This is what the Federal Reserve has done for the past year and a half, and continues to do. Why? The Fed and its apologists say the funds rate was raised to invert the yield curve in order to curb “inflationary pressures.” By raising the funds rate, they argue, aggregate demand is reduced, slowing production and raising unemployment. This, they contend, reduces inflationary pressures that would otherwise come from demands for higher wages and more consumer goods from working people. Put people out of work and they are not so demanding, although it costs the price of handouts.

In August, 2007, I wrote that this Fed policy caused the sub-prime mortgage crisis by intentionally destroying jobs held by people who live in homes financed by sub-prime mortgages. These are precisely the people whose employment exists at the margins of the economy. Raise credit costs to slow production, and theirs are the jobs that get cut.

The Fed does this purposely, so one might expect the Fed governors to step up candidly and accept responsibility. After all, this is the professed monetary policy practiced by the most powerful central bank in the world. To the contrary, however, the Fed is nowhere to be seen when it comes to explaining to the president or to Congress that throwing sub-prime mortgage borrowers out of jobs is really its intention, and its policy is “working” in the sense that many sub-prime borrowers have lost their jobs.

This is confirmed in recent analysis by Standard & Poor’s chief economist David Wyss, who reported last week that payroll and unemployment statistics are far more significant than interest rate resets in producing mortgage foreclosures. Wyss found that only 2% of mortgage foreclosures in 2007 were caused by interest rate resets under adjustable rate mortgages, according to data released by Countrywide Financial. Yet 60% of mortgage foreclosures were due to loss of jobs! Way to go, FOMC!

Politicians, economists and pundits ought to think about that before announcing through the media that a lot of people took loans they couldn’t afford to repay, or that greedy mortgage lenders made loans to people they should have known were dead-beats. Try walking in the shoes of those who are pawns of U. S. monetary policy presently imposed by Fed central planners before jumping to such overbroad conclusions.

Indefensible monetary policy is one of the two major problems troubling the U. S. economy and the financial markets. The other problem is fiscal policy, meaning taxing and spending by the federal government. The ever-present and growing threat is existing law that will automatically raise tax rates very significantly at the end of 2010 unless the law is amended. As the November elections approach, the markets become more convinced of the likelihood that this ax to economic growth will actually cut deeply into the nearly 40% growth in GDP experienced since the May, 2003, tax cuts.

This concern grows by the day. It will be made worse, not better, by passage of the irresponsibly cobbled-together “stimulus package” that is really nothing more than another exemplification of out-of-control “earmarks” by Congress. Let’s “earmark” checks to millions of individuals in various political constituencies and call the payments “tax rebates,” regardless of whether the individuals paid taxes or how much taxes were paid. Just be sure the checks are in the mail by the time Congress recesses for campaigning before the November elections. Earmark $150 billion for these “pet projects” of getting representatives and senators re-elected, while incidentally creating an excuse that Congress cannot “afford” to extend the 2003 tax cuts beyond 2010.

This is why markets and Americans are uncertain the economy is sound. The United States has completely irresponsible monetary and fiscal policies, and our policies are driving the global economy into the ditch, along with our own.

Stop the tax rebate earmarks. Extend the existing tax rates indefinitely. Float the Fed funds rate and stabilize the dollar relative to the price of gold by managing liquidity towards that objective. As the Fed proceeds to insist that the dollar price of gold has no significance to its currency, other central banks are discretely moving to build gold reserves instead of dollars. Every producer of oil or any other product knows why, but apparently Fed theoreticians do not. Just giving the point a little thought could be beneficial to all.

The Applied Finance Group pioneered the use of a process we call Value Expectations to help us understand what is priced into a stock price. Essentially, this process allows us to determine the sales and margin levels a company must generate to justify its current stock price. For example, prior to the technology bubble, in 1994, the market price implied that Cisco Systems would generate 0% sales growth over the next five years. Those lucky enough to buy the stock, benefited from Cisco outperforming the S&P 500 index by approximately 65% a year. Conversely, during the height of the technology bubble, in July 2000, the market priced Cisco Systems to grow at 65% a year, 50% above its average performance relative to its past three years. Its not surprising that as Cisco failed to deliver on that performance; its stock significantly underperformed the S&P 500. As this Cisco example demonstrates, by understanding the performance expectations embedded in a company’s stock price, investors are in a much stronger position to understand the risk/return investment decision behind an investment at a point in time. With that in mind, let us evaluate Harley Davidson at the start of 2007, and today.

Entering 2007, Harley’s previous 3-year median sales growth was approximately 8.5%. With its 2006-year end price of $70.47, the market priced Harley to grow at 7% a year over the next 5 years. While certainly not outrageous given the company’s recent track record, the market certainly expected the future 5 years to mirror the past 3. Given that the consumer was starting to tire, and oil prices and interest rates were on the rise, such expectations in hindsight appear to be a bit rich. Clearly as Harley under-delivered relative to those expectations in 2007, it’s not surprising that its stock price tumbled. Interestingly now, with the stock trading near 5 year lows, the market has taken a very bearish stance on the company. Friday’s closing price implies that the market expects Harley’s sales to decline 9% a year over the next 5 years. While anything can happen over the course of 5 years, it seems that such expectations are severely harsh for a number of reasons. First, management currently is guiding for low single digit sales growth in 2008. That seems plausible, and should they have flat to negative growth, then a sub $40 price provides a reasonable cushion for error. Second, for investors with a long-term investment horizon, Harley’s international trends are very promising. For 2007, international units accounted for 27% of all shipments, compared to 21% in 2006. Given the low expectations embedded in the current price, investors may very well be rewarded for such growth. Lastly, because the company tends to ship fewer units than consumer’s demand, the pent up demand should lead to greater sales as the economy improves and consumers become more confident. All told, these factors indicate that at current price levels HOG is likely to deliver patient investors superior long-term returns.

As every little piggy knows, sometimes you need to get in the slop to make some bacon.