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To support the new regulatory mindset is to assume that economically-free countries, as opposed to those centrally planned, are frequently burdened with sclerotic growth and commercial failure. One would also have to take a giant intellectual leap backwards in the direction suggesting that government bodies free of the discipline wrought by the marketplace are somehow better suited to solve the problems before us. In truth, it is private interests, those that operate fully accountable to consumers and investors, who regularly adapt to all manner of changes in what is a highly fluid economy.

Apparently forgotten by our Washington minders is that the U.S. and the world shifted to more of a laissez-faire style precisely because heavy regulation proved so wanting when it came to fostering a high level of economic vitality. Indeed, it was the process whereby the U.S. and other countries shed the discredited views dictating economies needed to be managed from the “Commanding Heights” that led to the economic renaissance of the ‘80s and ‘90s.

When we learn that our leaders want to backtrack from what proved so successful, we have to ask if the people to whom we’ve entrusted power are really so obtuse as to believe we were better off in the era before free markets ascended as the Rule. To the extent that our leaders are intoxicated by the “fatal conceit” suggesting the infinite decisions that are the marketplace need regulation, we should eagerly remind them of their faulty thinking.

Perhaps it’s shooting fish in a barrel, but when we consider the economic calamities of the 20th and 21st centuries, all occurred due to too much governmental involvement in the economy, as opposed to too little. The legislative error that was Smoot-Hawley triggered the 1929 stock-market crash, and in its aftermath, all manner of legislative mistakes that turned what would have been a minor downturn into the Great Depression.

The unfortunate malaise of the 1970s was once again not a function of markets not working, but instead the result of President Nixon severing the dollar’s link to gold. The inflation that ensued drove already high levels of taxation even higher, and made investment and countless forms of economic activity less profitable. When we consider the gas lines experienced during the ‘70s, rather than a signal of market failure, they were the result of pricing regulations that reduced incentives for retailers to bring petroleum to the market.

Despite the triumph of free markets in the 1980s and beyond, government still inserted itself at times, and among other things, we have the S&L disaster to show for it. Rather than something that resulted from market failure, the federal government’s efforts to prop up an S&L industry that served no market purpose led to the privatization of profits and socialization of losses that cost American taxpayers billions.

More modernly, the imposition of Sarbanes-Oxley as a reaction to the unfortunate implosions of Enron and Worldcom turned what was mostly a non-event for stocks into a market rout as CEOs were forced to become accountants rather than innovators. And if we ignore the likelihood that FEMA’s very existence is a violation of the Constitution, the former’s ineptitude in the wake of Hurricane Katrina was useful as a “teaching moment” about the effectiveness of government in contrast with the brilliant efficiency exhibited by Wal-Mart in response to the same hurricane.

During his press conference at which he announced the new regulatory structure, Paulson said, “We know that a housing correction has precipitated this turmoil, and housing remains by far the biggest downside risk to our economy.” If we ignore his questionable economic analysis about the role of housing in any economy, we can say that the federal government created the problems we’re experiencing today through the weak dollar it has issued in this decade alongside massive subsidization of the housing market; subsidization that gave Washington the power to lean on lenders in ways that lending standards were made less stringent.

And when we address what is called the “subprime debacle,” can’t we at some point ask if anyone expected anything less than what we’re now experiencing? Subprime loans are thus described precisely because they’re risky. Rather than expressing shock at the rising rate of foreclosures in the housing market, we should say that markets are working very efficiently in that subprime borrowers are to some degree expected to walk mortgages. The irony here is that absent problems in this space, mortgage lenders would likely have been brought before Congress to explain the “exploitation” of borrowers who’d proven able to make payments at usurious rates.

On the financial front, Paulson seeks to expand the turf of the Federal Reserve as “Market Stability Regulator” given its traditional “role of promoting overall economic stability.” The mind races when confronted with the absurd notion that the Fed has had much to do with “overall economic stability,” but needless to say it seems folly to assume that a body wholly incapable of issuing a stable unit of account (and seemingly not desiring to do so either) should somehow be given even more regulatory oversight.

The reality is that markets being markets, they’re supposed to be unstable at times as new industries and innovations push out the old. But if we ignore the latter, we should say that just as the Fed and the rest of federal government have traditionally been late to commercial mistakes invariably discovered by private interests, the notion that a reconfiguration of the doings of career civil servants will somehow make them more effective market watchdogs is too silly for words.

The other shame here is that we’ll never know what might have happened had the Federal Reserve ignored the problems at Bear Stearns. We’re told that the health of the world financial system made the Fed’s actions necessary, but that being the case, it seems fair to assume that absent the presence of our central bank, private interests would have worked out a solution given how much money was at stake. That the financial establishment invited the Fed to participate in the Bear Stearns debacle speaks to a Faustian bargain of impressive proportions when we contemplate the future regulations that will be demanded in return.

Despite the regulatory apparatus that he proposes, Paulson expects “that we will continue to go through periods of market stress every five to ten years,” as though good or calm times for the markets must necessarily lead to occasional meltdowns. Paulson misses the point. Stock markets buffet and economies stop growing not due to economic freedom, but due to governmental activity in the areas of money, regulation, trade, and tax that make productive effort less profitable. That Washington has regressed in this decade in three of the four areas mentioned largely explains why an investment in the S&P 500 Index nine years would presently yield no gains.

What the economy needs right now is for the government to sit back and let the problems before us slide into the proverbial ditch. Only then will the costs of unused capital of the human and technological variety reach market-clearing levels so that the economy can start growing again. Capitalism works, and it was our initial embrace of it that made the last twenty-five years so abundant. Now is not the time to abandon it.

Upon reaching the Oval Office, the new president’s first economic program meant to reverse an economic slowdown was not marginal tax rate cuts, but $80 billion in tax rebates. Though the latter merely shifted money from one set of hands to another, the president promoted the rebates in a Keynesian light meant to “put more money in peoples’ pockets.”

When it came to trade, this administration quickly slapped a 30 percent tariff on certain kinds of foreign steel, and followed up with tariffs on soft-wood lumber and shrimp. So bad was the administration’s reputation when it came to trade that Brink Lindsey of the libertarian Cato Institute felt compelled to point out that “U.S. credibility on trade, internationally, is hovering near zero.”

Not done erecting economic barriers, the administration chose to harass a country that had recently shed its statist economic policies in favor of a strong embrace of free markets. Though China sought to speed its escape from the crushing drudgery that was communism through a yuan/dollar link, one that facilitated an explosion of trade between two countries formerly at odds, the president regularly sent top Treasury officials over to Beijing in hopes of convincing China to de-link its currency from the dollar. The intent there was to make Chinese goods more expensive (meaning less competitive) in U.S. markets.

In late 2001, and in May of 2002, formerly blue-chip firms Enron and Worldcom respectively imploded before our eyes. Despite the severity of those high-profile collapses, stock markets took the failures in stride. Indeed, the Dow Jones Industrial Average fell a total of 3 percent over the period that both companies went under. Markets adjusted as they always do.

The problem going forward was that the administration felt the need to act in order to rid executive suites of alleged corporate malfeasance. The Department of Justice opened up more than 100 corporate investigations, while filing charges against over 150 people. An indictment of Arthur Anderson alone led to the loss of 80,000 jobs and untold wealth given the firm’s inability to survive the DOJ’s effective death sentence.

Not content there, the president signed Sarbanes-Oxley into law, describing it as “the toughest piece of anti-fraud legislation since FDR.” Among other things, Sarbanes-Oxley foisted strict, time-consuming accounting rules on public firms irrespective of size, and it required public-company CEOs to sign off on the veracity of accounting statements with heavy personal liability if they were later proven incorrect. Talking about the impact of the new rules, Xerox’s Anny Mulcahy noted at the time that there is a “drive for averageness” in corporate suites today. And with the markets sensing the likelihood that CEOs would be forced to act more like accountants than entrepreneurs, the S&P 500 fell 175 points in the three weeks surrounding Sarbanes-Oxley’s passage.

And when we think about Sarbanes-Oxley, we have to consider the power of entrenched political classes to pass laws mostly free of consequence at the ballot box. Canadian economist Reuven Brenner has written about how “unfettered campaign finance allows the decentralization of influence.” The latter is what is required for economies to thrive, so it’s essential that politicians don’t ever become so powerful such that they can retard economic growth with myriad rules and regulations.

This is important considering the president was sent a campaign finance bill (McCain-Feingold) authored by a Republican and Democrat; one meant to restrict the ability of individuals to contribute money in ways that would influence voting, and the making of policy more generally. Though he could have vetoed the unconstitutional restrictions on free speech littered throughout the bill, the president signed it. Thanks to McCain-Feingold, politicians now possess an even greater ability to pass economy-enervating laws without fear of facing a well-financed opponent who might shed light on how those rules impoverish us.

To classical economic thinkers government spending isn’t just unfortunate for the debts incurred on the backs of future generations, but more troublesome for capital being siphoned away from the productive sector into immediate government consumption. When it came to spending, the administration in question was highly profligate.

With the wind at his back after signing farm and prescription-drug bills, the president oversaw what Cato Institute scholar David Boaz describes as “the biggest expansion of entitlements since the LBJ years.” Though the president parroted his predecessor (Bill Clinton) in promising to “cut wasteful spending and be wise with the people’s money,” his desire to show “compassion” meant he never vetoed a spending bill of any kind during his first seven years in office.

Of course, one way for governments to reduce the level of debt wrought by spending is to debase the currency. And when it came to poor dollar management, this president and the monetary authorities he appointed were particularly effective.

Beyond the aforementioned tariffs and jawboning of China that were an implicit admission on the administration’s part that it would prefer a weaker dollar, the president appointed Treasury Secretaries who publicly mocked the value of a strong greenback. His first Treasury chief noted that a “strong dollar” meant little in policy terms. The latter’s successor asked at a G-8 meeting in France, “What’s wrong with a weak dollar?”

Talking up the qualities of his third Treasury secretary, the president said he “will insist on fair treatment for American businesses, workers and farmers,” plus he’ll seek to “maintain flexible, market-based exchange rates” for currencies of trading partners. The comment about “market-based exchange rates” was a clear signal from the president that his new appointee would utilize strong ties within the Chinese government in an effort to convince Chinese officials to end the dollar/yuan peg.

The president also got the chance to select a new chairman of the Federal Reserve, and when given the opportunity, nominated someone of ambiguous political leanings. The nominee was a self-professed expert on the causes of the Great Depression; his alleged insight the incorrect view that our being on the gold standard was the cause. And when asked what would solve Japan’s economic problems back in 2000, the nominee perhaps tipped people off to his broad economic views given his assertion that, “Perhaps it’s time for some Rooseveltian resolve in Japan.” The comment about Japan of course raised further questions about any expertise when it came to understanding our Depression in the 1930s.

When we look at the dollar, since 2001 the president’s chief monetary authorities have overseen its fall to levels previously unseen. Indeed, gold is presently at all time highs, while the dollar has reached new lows against every major currency. Despite the aforementioned signals which scream inflation, the Treasury secretary maintains a stance of “benign neglect” toward the dollar, while the Fed chair remarkably sees inflation moderating in the coming quarters given his view that slow growth is an inflation cure.

As one would expect, the falling dollar led to quite a bit of economic dislocation such that our economy is now thought by 75 percent of Americans to be in recession according to the latest polling data. Seeking to fend off any downturn in what is the president’s last year in office, rebates have once again been offered up to increase “aggregate demand.” This has occurred in concert with Treasury interventions in the mortgage market along with a recent Federal Reserve bailout of a collapsing investment bank.

The Wall Street Journal recently reported that the result of all the economic uncertainty “will be a heavier hand of government in the form of corporate bailouts, fiscal incentives and regulation.” When asked for his thoughts on the increasingly muscular actions of federal officials, the president said, “My comment is that the Treasury Department and the Fed are taking swift action.”

So who is this president? There’s no riddle here in that presumably none of us have been on an island over the last seven years. President George W. Bush, a Republican, has overseen a massive increase in the size and scope of government on his watch, and did so in conjunction with a collapsing dollar that has surely marginalized by now any of the gains enjoyed from the tax cuts he signed into law in 2003.

Still, if any of us had been secluded for the past seven years, a description of the Bush years without attribution would likely have had most any Republican assuming a Democrat had been in control. Is there an explanation for this? The first one would be that all politicians disappoint. By definition. Beyond that, given the statist direction taken by the Republican party in this decade, it’s fair to ask if it any longer represents laissez-faire growth. Many would point to the even harsher anti-growth views held by Hillary Clinton and Barack Obama, but it seems a lot of their stances at present are pure politics.

Even if they’re not, it would be hard to find an administration in modern times that has been more interventionist than the present one. That in mind, stinging losses for the GOP may be just what the doctor ordered. Indeed, maybe the pain of being out of power will force them to look inward, and in doing so, perhaps understand that when a Democrat runs against a Democrat, a Democrat always wins.

He is spending upward of $9 billion more to build 13 additional casino hotels in Macao, and about $4 billion on one in Singapore. Next? Perhaps India, Japan, Korea, Thailand. Certainly Bethlehem (Pennsylvania, that is -- really).

Macao's gambling revenue, which surpassed the Strip's in 2006, soared 46.6 percent last year to $10.4 billion. Macao's February revenue was up 67 percent over February 2007. Las Vegas is largely immune to U.S. economic cycles: In January, the Strip's casino gambling revenue fell only 1.3 percent, and a few "whales" could make up that margin over a weekend.

Whales, in the language of Las Vegas, are, Adelson says, those who can win or lose $3 million in one stay. There are only a few thousand whales in the world, but they are multiplying fast in China -- thank you, People's Republic. Adelson says that when 60,000 people a day are gambling at Macao's Venetian, 40 percent of the casino's revenue comes from 59,700 of them, and 60 percent from 300 others, probably including three to eight whales. In the Venetian here, 20 percent of the gamblers provide 80 percent of the revenue. Business cycles do not dent Adelson's confidence that the rich will always be with us: "The upper end is never vulnerable."

Adelson brandishes for a visitor a June 20, 1955, issue of Life magazine, the cover of which asks if Las Vegas is "overextended." The city then had fewer than 3,000 rooms. Today it has 138,000, and 45,000 more are under construction or planned. Although Adelson thinks gambling will remain this city's motor and scoffs at the notion of Las Vegas becoming primarily a "family destination," he does think it will become to Southern California what south Florida has been to the Northeast. What Northern winters did for Florida, California's government (high taxes, low performance) will do for Las Vegas.

Far from threatening Las Vegas, state governments, America's foremost promoters of gambling, have, Adelson says, "enlarged the market." State lotteries (and casinos -- 28 states have them) whet people's appetites for a trip to gambling's mecca.

A long-running show at the Hilton here is "Menopause: The Musical." While the number of Americans over 65 has increased 20 percent since 1990, in Nevada the number has increased more than 100 percent. Poet Philip Larkin once said he would like to go to China if he could be home for dinner. Adelson and other makers of modern Las Vegas have obliged people like Larkin, sort of.

The Venetian has gondolas plying indoor canals that, unlike Venice's, do not smell: "Score one for the Americans -- when they rebuild Europe," Paul Cantor of the University of Virginia writes, "they correct it, they improve it, they get it right." Las Vegas's hotel casinos also include Paris, and New York New York. Las Vegas, says Cantor, "fulfills a deep-seated American dream -- to be able to pack the whole family into the station wagon and drive to Europe."

Frommer's guidebook suggests that there should be a Hoover Dam Hotel and Casino -- why drive 30 miles when you can see a replica on the Strip? This, says Cantor, is democracy -- giving the masses access to the world, albeit radically reduced.

Thanks to Adelson, Macao has its Venetian -- a replica of a replica of a city. So China has passed into postmodernism's erasure of distinctions between high and low culture, and between originals and copies, without yet achieving modernity. Buffett and Gates may still be richer, for now, but Adelson's achievements astonish and multiply.

georgewill@washpost.com

If the Rules are Inconvenient, Change the Rules

Several times in the past few months I have reminded readers of the problem that developed in 1980 when every major American bank was technically bankrupt. They had made massive loans all over Latin America because the loans were so profitable. And everyone knows that governments pay their loans. Where was the risk? This stuff was rated AAA. Except that the borrowers decided they could not afford to make the payments and defaulted on the loans. Argentina, Brazil and all the rest put the US banking system in jeopardy of grinding to a halt. The amount of the loans exceeded the required capitalization of the US banks.

Not all that different from today, expect the problem is defaulting US homeowners. So what did they do then? The Fed allowed the banks to carry the Latin American loans at face value rather than at market value. Over the course of the next six years, the banks increased their capital ratios by a combination of earnings and selling stock. Then when they were adequately capitalized, one by one they wrote off their Latin American loans, beginning with Citibank in 1986.

The change in the rule allowed the banks to buy time in order to avoid a crisis. It did not change the nature of the collateral. They still had to eventually take their losses, but the rule change allowed both the banks and the system to survive. I have made the point that the Fed and the regulators would do whatever it has to do to manage the crisis.

All the major new multi-hundred billion dollar auctions at the Fed where the Fed is taking asset backed paper as collateral for US government bonds does not make the collateral any better, of course. It just buys time for the institutions to raise capital and make enough profits to eventually be able to write off the losses.

Thus it should not come as a surprise to you, gentle reader, that the rules have been changed in much the same way as in 1980. In an opinion letter posted on the SEC website last weekend clarifying how banks are supposed to mark their assets to market prices is this little gem (emphasis mine):

"Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability."

(The full letter is at http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm.)

So, now banks can simply say that the low market prices for assets they hold on their books are actually due to a forced liquidation or distress sale and don't reflect what we believe is the true value of the asset. Therefore we are going to give it a better price based on our models, experience, judgment or whatever. In today's Continuing Crisis, nearly every type of debt and its price can be classified as a forced liquidation or distressed sale.

Does this make the asset any better? Of course not. But it buys time for the bank to raise capital or make enough profits to eventually take whatever losses they must. And who knows, maybe they will get lucky and the price actually rises?

There are two problems with this rule. First, it clearly creates a lack of transparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company.

Second, can a forced liquidation or distress sale be from a margin call? Obviousy the answer is yes. But as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then they find out that the investment bank is valuing them differently on their books than the price at which they were forced to sell, there will be some very upset managers and investors. Cue the lawyers.

Is this a bad ruling? Of course. But is it maybe necessary? It just might be. My first reaction was that this tells us things are much worse than we think. The struggle to get the mark to market ruling only to abrogate it in certain circumstances less than a year later has to gall a lot of responsible parties. It seems like it is 1980 and Latin America all over again. Let me repeat: The Fed and the Treasury (who oversees the SEC) will do what it takes to keep the game and the system going.

Let's Re-arrange the Deck Chairs

Treasury Secretary Hank Paulson put forth a number of "new" ideas for changes in the regulatory structures. Nothing I saw will help all that much in the current crisis. It's more like re-arranging the deck chairs as the ship is going down. It seems like most of it is being proposed to prevent another crisis like the one we are in from occurring in the future. That simply insures that Wall Street will have to invent whole new ways to create a crisis in the future. I am sure they will be up to the task.

Most of the proposals are basically good ideas that have been discussed for a long time, like merging the CFTC (Commodity Futures Trading Commission) and the SEC. We are the only country with such a bifurcated regulatory system. Good luck with getting that through Congress, though. The Agricultural Committees in the Senate and the House oversee the CFTC and futures trading, dating back to the 1930's when all that was traded was agricultural products. Now the CFTC oversees a vast derivatives market, which of course makes campaign donations to members of those committees. Think those Congressman want to see their major campaign donors go away? Of course, that means the Finance Committees would get new donors. It will be amusing to watch and see who "wins."

The really interesting item is the potential for the Fed to regulate investment banks, which makes some sense if they are going to loan them money at the discount window. Left unsaid and up for future negotiation is whether that would mean investment banks would have to reduce their leverage. Right now, investment banks utilize about twice the leverage as commercial banks. That leverage is what makes them so profitable. Take that away and they lose a lot of their profit potential.

A great part of the continuing crisis can be laid at the feet of too much leverage in too many places. The world is de-leveraging fairly rapidly. In some circles, it looks more like an implosion. The Fed and the SEC have made it very clear they want to have more authority to oversee all sorts of funds and investment banks so they can get a handle on the amount of leverage in the system. What you do with that information is another thing, but they want it and will use the Continuing Crisis to get that authority. My bet is that investment banks are going to be forced to reduce their overall leverage "for the good of protecting the system from itself" or some such twisted logic.

So, let's sum it up. The problem is so severe with the financial companies assets that the SEC is going to allow some of them to "cook the books" so they can survive. That means there are going to be large and continuing write-downs for many quarters to come. There is a minimum of another $3-400 billion in write-downs (and maybe a lot more) coming from mortgage related assets, not to mention credit cards and other consumer related debt. And the investment banks may be forced to reduce their leverage and thus their profitability?

Putting money in the major financial stocks is not investing. It is gambling on a very uncertain future. There is simply no way to know what the value of the franchise is. There are other places to put your money.

Regulations Coming to a Hedge Fund Near You

The SEC pushed through rules last year to regulate hedge funds. The courts ruled (properly, I think) that the SEC did not have congressional authority to do so. The hedge fund industry fought tooth and nail to avoid regulation and dodged the bullet.

I think the mood in Congress is going to be such that as the authorization for many of Paulsen's proposed changes make their way through Congress, some of them are going to allow the SEC the authorization they need to regulate hedge funds. The Continuing Crisis almost makes it a sure thing.

So, a quick note to my friends in the hedge fund industry. Forget fighting regulation and start negotiating. Recognize that regulations are coming and do what you can to make them as rational as possible. Also, make sure you (we) get the rights of other regulated funds, like the ability to advertise and not be so secretive, at a minimum. And maybe a more reasonable interpretation of the research analyst rules, which I note that many seem unaware of the implications on hedge funds and private offerings of the research analyst rules.

I am regulated by FINRA (the former NASD) which is overseen by the SEC, the NFA (the self-regulatory arm of the CFTC) and various state financial authorities. It seems like we get a regulatory audit almost every year from someone. My small firm survives, and so will hedge funds. Does it cost a lot of money and time to be regulated? Sure. But that is the price of doing business.

Will making hedge funds register make them any safer? I doubt it. Think of Enron and WorldCom. REFCO was registered and somehow hid a $500 million dollar bogus loan from regulators, their investment bankers and auditors. But it will make them more transparent. If we are going to have to pay the costs of being regulated let's make sure we get the benefits.

More Fun in the Unemployment Numbers

Payrolls tumbled by 80,000 today, more than forecast and the third monthly decline, the Labor Department said today in Washington. The unemployment rate rose to 5.1%, the highest level since September 2005, from 4.8%. The household survey shows the number of unemployed people rose by 438,000. (That is not a typo!) In March, the number of persons unemployed because they lost jobs increased by 300,000 to 4.2 million. Over the past 12 months, the number of unemployed job losers has increased by 914,000.And of course, when you look into the numbers it is worse than the headlines implies.

Prediction: we will see 6% unemployment before the end of the year.

There were negative revisions totaling 67,000 job losses for the last two months, making those months even worse. This means that the Bureau of Labor Statistics (BLS) is clearly over-estimating the number of jobs in the first announcement. That is because they have to extrapolate based on recent past data. And as I continually point out, as the economy softens, they are going to continue to overestimate the number of jobs. It's one of the problems of using past performance to predict future results.

Job losses since December are now at 286,000 in the private sector and 232,000 overall, counting for growth in government. What was up? Health care (23,000) and bars and restaurants (23,000 also). Initial unemployment claims are up by almost 25% for the last four weeks over last year, and this week were over 400,000. Given the job losses, this is not surprising.

This month the BLS hypothecates 142,000 jobs being created in their birth/death model. You can guarantee this will be revised down. For instance, they assume the creation of 28,000 new construction jobs as the construction industry is imploding. Total construction spending has fallen for the last four months in a row. Somehow they estimate 6,000 new jobs in the finance industries. Does anyone really think we saw a rise in employment in mortgage and investment banks?

Buried in the data is a picture of a squeezed consumer. Inflation is now running ahead of the growth in wages. As the chart below shows, average hourly earnings were up just 3.6%, but inflation was 4.5%. That means consumers must struggle to maintain their standard of living. No wonder retail stores shed 12,000 jobs last month. Light vehicle retail sales are down by 20% form last year. This all paints a picture of a very challenged consumer.

A Muddle Through Recession

The business sector is clearly in recession. The ISM manufacturing index came in at 48.6. Anything below 50 means manufacturing is in decline. There was a sharp drop in new orders. New orders have been below 50 for four months. Employment has been below 50 for four months. Backlog of orders has been well below 50 for six months. Yesterday the ISM service index was again below 50 for the month of March.

Given all the data, why then do I still think we will not see a deep recession? Because corporate America is in much better shape than in the beginning of past recessions. Lower inventories, better cash to debt ratios, not as much as excess capacity, and so on. As Peter Bernstein notes in his latest letter, nonfinancial corporate debt is at its lowest level in 50 years, and four standard deviations below the average from 1960 to 2000.

The recession we are now in is a consumer spending led recession driven by a falling housing market which is infecting the entire country. Can anyone still claim that the subprime problems would be contained as many did just last summer? Consumer spending is going to fall even more as credit becomes harder to get.

The situation is neatly summer up by Bernstein:

"The debate over whether we are or are not in a recession continues. There is, however, no debate about resumption of rapid economic growth in the near future. That's without question the most unlikely outcome. Yes, there are some bright spots, such as exports in the governmental largess that lies just ahead - and the likelihood of additional government assistance in some form. The Federal Reserve is also doing its part to lubricate the snarls in the financial markets.

"But the household sector is in deep trouble and will remain in trouble for an extended period of time. The combination of falling home prices, the complex problems in the mortgage area, limited financial resources and high debt levels, new constraints and higher costs on consumer installment credit, and probably rising unemployment already sluggish growth and jobs tend to restrain spending by the largest and most important sector of the economy.

"Imagine what would happen if all of these adverse forces struck a business sector stuffed with inventories, busy installing a massive amount of new productive capacity, with labor costs rising and productivity falling, and an overload of new debt to service. A difficult situation in the rest of the economy could be rapidly converted into a deep recession. But the business sector has kept inventory accumulation to a moderate pace, has limited in capacity growth, and has been conservative in adding to debts outstanding. How lucky can you get?

"Some observers are convinced that we are heading toward a deep depression in any case. We are not so sure. We believe the likely duration of these troubles is a greater concern than the depths the system might reach. The condition of the business sector as pictured above is the primary reason for this more hopeful outlook."

But a recession for at least two quarters and a Muddle Through Economy for at least another 18 months is not going to be good for consumer spending, job creation and most especially corporate profits. I continue to predict more disappointment for corporations that are tied to consumer spending and industries that are associated with housing.

S&P analysts continue to project earnings to be up by 15% in the third quarter of this year and by almost 100% for the fourth quarter this year over last year. Yes, I know there are a lot of one time charges and write-offs in the last two quarters of last year which make comparisons difficult. But in a recession and a slow recovery, how likely is it that we will not see even more "one-time" write-offs. And as noted above, there are more than twice as much subprime losses in our future as we have written off as of yet.

As I have written about at length in past issues, bear markets are made by continued earnings disappointments. It typically takes at least three difficult quarters to truly disappoint investors. We are just in the early stages. The recent drop in the stock market has been primarily caused by the Continuing Crisis in the credit markets, and only modestly by disappointing earnings. We need a few more quarters of disappointment to really get to a bottom in the stock market. It could be a long summer.

How Much do we Borrow for a $1 growth in GDP?

Finally, I want to give you a chart from my old friend Ian McAvity from his latest newsletter Deliberations, which he has been writing for 36 years! Basically, it makes the point that the amount of new debt in relationship to GDP is rising. We borrowed in one form or another $5.70 for each $1 rise in GDP last year.

Debt in all forms rose $7.86 trillion for the previous 8 quarters to $48.8 trillion dollars. Nominal GDP was only $14.1 trillion. This is of course unsustainable. At some point, debt growth must slow dramatically. As the world deleverages, decreasing debt and the resultant slowing of consumer spending will become a head wind for GDP growth.

London, Switzerland and South Africa

Next Wednesday I head out to California for my 5th annual Strategic Investment Conference in La Jolla. It is completely sold out for the first time. My partners in the conference, Altegris Investments have been doing yeoman work to make it come off in high fashion, and I thank them. I return and immediately head over to London and then Switzerland. I will be speaking for Bank Sarasin at a resort in Switzerland in the Interlaken area, and will stay on for a few days to be tourist and take some needed R&R and fly back on Monday evening.

I will be in South Africa in Johannesburg from May 5 - 8 and in Cape Town from May 12 - 14. If you are interested in attending my presentations you should contact Prieur du Plessis. You can use the contact button on his excellent blog: www.investmentpostcards.com.

I am going to try and play golf for the first time in at least a year. I will be terrible, but I will be playing with good friend and savvy commodity trader Greg Weldon and I look forward to it. Then in the afternoon two of the best Science Fiction writers and futurists in the world, Vernor Vinge and David Brin are going to join me, serious technology maven Dr. Bart Stuck and financial guru and brilliant thinker Rob Arnott for two hours of rambling conversations about the future. My daughter Tiffani wants to record it, and if we do (and with everyone's permission) we will post it on the net. Then 240 new and old friends gather Friday and Saturday to hear some really interesting speakers and enjoy each other's company. It looks to be a great week.

I hope you can enjoy your week as much as I will. And make it a good one. Now if the Rangers can just win their home opener on Tuesday, it will get even better.

Your amazed at how lucky I am analyst,

John Mauldin
John@FrontlineThoughts.com

Copyright 2008 John Mauldin. All Rights Reserved

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PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

Undrafted out of high school and cut from the 1988 U.S. Olympic baseball team, future Hall of Fame baseball player Frank Thomas ultimately got called up by the Chicago White Sox for the 1990 season. From 1991 to 1997 Thomas finished in the top 10 of MVP voting every season; winning the award twice in ’93 and ’94. By the time Thomas left the world champion White Sox in 2005 he was the team’s all-time leader in home runs, walks and slugging percentage.

Still, Thomas left Chicago under a controversial cloud with team executives of the belief that his skills had diminished. With his value as a player in freefall in the eyes of baseball GMs, Thomas was reduced to signing a $500,000 contract with the notoriously cheap Oakland A’s. Happily his story didn’t end there. Thanks to his willingness to accept his new market value, Thomas went out and hit 38 home runs in 2006; success that led to a 4th-place finish when the media voted on the AL’s Most Valuable Player. After his season with the A’s, Thomas proceeded to sign a 2-year, $18 million dollar contract with the Toronto Blue Jays.

Shunned as a football recruit by the University of Southern California during high school, Tom Brady signed with the University of Michigan and was relegated to seventh on its deep depth chart of quarterbacks. Brady played behind Brian Griese for two years, then battled with “can’t-miss” recruit Drew Henson for the starting job during his final two seasons as a Wolverine. Though he ultimately won the starting job and secured All-Big Ten honorable mention honors both seasons, Brady slid all the way to the 199th pick of the 2000 NFL Draft; drafted behind NFL also-rans including Giovanni Carmazi, Chris Redman and Spergon Wynn.

Importantly, his low cost relative to other draft-eligible players made him more appealing to the New England Patriots and coach Bill Bellichick. Although he started out 4th on the Pats’ depth chart, Brady bided his time under Drew Bledsoe, and when the latter went down with a serious injury on September 23, 2001, Brady stepped in and led his team to victory in 11 out of 14 regular season games before quarterbacking them to Super Bowl XXXVI. Three Super Bowl victories later, and one league MVP on his resume, Brady will surely be a first ballot Hall of Famer when he eventually retires.

Famous today for its revitalized Art Deco buildings, as recently as the 1980s Miami’s South Beach section was considered very poor and run down, and had a high rate of crime. Glamour when it came to the southernmost section of Miami Beach was a distant memory.

But where the average individual sees failure, the entrepreneur sees opportunity. Agent Irene Marie opened Irene Marie Models (Miami’s first full service modeling agency) in 1989 in the former Sun Ray apartment building, and hotelier Ian Schrager soon followed with the opening of the Delano Hotel. Schrager is famous for finding areas down on their luck, and opening hotels that attract the glamorous and even more development. What was formerly a run-down area of faded beauty now attracts the world’s beautiful thanks to previously collapsing values that made new investment possible.

During the first third of the 20th century, Pasadena, California was a resort town for well-to-do Midwesterners eager to escape the winter chill of the Midwest. Prominent industrial families including the Wrigley’s, the Gambles and Huntingtons constructed remarkable winter homes that still stand today. Colorado Boulevard stood as the equivalent of Beverly Hills’ Rodeo Drive, and it was where the rich went for shopping, food and entertainment.

Sadly, the Great Depression hit Pasadena hard, and by the 1970s formerly alluring Colorado Boulevard had been reduced to a combination of seedy bars, pawn shops and adult bookstores. Rather than a place to stroll, it became a street to avoid. But with property values at their nadir, entrepreneurs did what they always do in sensing value where others don’t, and soon enough restaurants, movie theaters and clothing stores revitalized a street that once served as a symbol of urban decay.

And when we look to New York City, formerly abandoned and inexpensive areas such as Tribeca, the Meat Packing District and the East Village now compete with midtown and uptown Manhattan for residents and top chefs. So great has Manhattan’s revitalization been that previously down-market areas outside the borough such as Brooklyn’s Williamsburg are now considered very fashionable.

The stories found in the sports and property sectors take on new relevance amid attempts by our political class to shield us from the difficulties that arise when an economy slows. Much is being made by politicians of reduced demand for workers and property, and to fix this seeming shortfall, a bipartisan effort is afoot to aid both. Low-income workers will receive checks from the federal government, while Illinois Senator Dick Durbin (D) is seeking an extension of unemployment benefits. On the property front, Congress is set to pass a $15 billion “housing stimulus package” meant to drive more home purchases through various tax breaks which would make a heavily subsidized sector even more reliant on state handouts.

The Washington consensus is a mistaken one; one rooted in the misbegotten belief that employment and housing slowdowns result from collapsing demand. That’s incorrect. Instead, our leaders should recognize that buyers of housing and labor disappear when both are supplied at rates above the market-clearing level. It’s only when prices are allowed to fall that intrepid buyers step in given their unending search for value.

So if we ignore for now the enervating quality of subsidies and handouts, we must say that they’re most problematic for pricing workers and housing at levels that make them unattractive to employer and investor alike. Indeed, as the examples from the sports and property world indicate, a great deal of success is conceived when markets are left alone to sort out all manner of prices. And if Washington simply steps aside, today’s property and employment showdowns will surely father more success stories.

It may sound contradictory, but there is a common thread: the policy programs once proposed to resemble Japan and now proposed to avoid her fate are virtually identical – as well as unworkable, and counter-productive.

In the days of “stagflation,” John Kenneth Galbraith and others pointed across the Pacific to the tightly regulated Japanese economy and lauded the close relationship between big government and big business. Therein lay America’s salvation, we were told.

Except the United States found salvation elsewhere, within ourselves, in our own uniquely American entrepreneurial spirit. And – unhappily for those always pining for central planning – to the extent that our economy was saved by direct action, it wasn’t more interference that did the trick, but a conscious choice to have less. And other factors that made a difference were largely unplanned, unforeseen, and bottom-up.

Deregulation stimulated entrepreneurial activity across the economy, in virtually every sector, from the biggest corporations to the smallest start-ups. It had a particularly revolutionary impact on the financial markets. Michael Milken's innovative way of breaking apart huge underperforming conglomerate companies – much derided at the time – gave the entire capital market a jolt of energy that continues to this day. It also pushed issues of corporate governance and performing for shareholders front and center.

As to the happy accidents, a case in point is the Employee Retirement Income Security Act (ERISA), passed by Congress in 1974. This law, among other things, established individual pension vesting. Later amendments effectively created the venture capital industry. As the economy worsened, engineers and other creative workers found that they could leverage their pensions to take risks on new ventures. Needing partners, they found them in the form of a new kind of co-risk taker: the venture capitalist.

Another happy accident arose from the Bayh-Dole Act. This legislation – not intended to encourage economic recovery – ended up doing exactly that. By clarifying that the results of federally supported research would be the intellectual property of the inventor (or his employer) and not the government, it provided a huge boost to human capital innovation. The incentives for discovery this law created continue to pay off every day.

America did not emerge from stagflation by becoming more like Japan, but by returning to its entrepreneurial roots. Yet now, our politicians tell us, America must avoid becoming more like Japan by turning our backs on those roots.

The list of prescriptions is wearying: more government regulation of the credit markets, new oversight for investment banking, consolidate government control of the public equities markets, develop housing scores, force consumers to listen to lectures before they buy a house, create mortgage guaranty funds, and on and on.

It’s not exactly a solution in search of a problem – no one can doubt that America’s economy in general, and the financial markets especially, are in a rough patch. But it is the wrong solution, for a problem that is not nearly so dire as the central planners suppose.

Focus on the credit crunch alone and things look dire indeed. But consider some of the other fundamentals. Over the last 25 years, America has enjoyed a period of enormous growth in productivity. Employment has been stable and close to full – a far cry from the 10 percent unemployment at the low point of the stagflation era. Nor do we suffer anything like the annualized CPI inflation rate of 13 percent.

In addition, the U.S. today can boast something that it didn't have in 1980. Since then America has rediscovered entrepreneurial capitalism. Entrepreneurs are the bedrock of our growth. They are responsible for most innovations, and thereby for the creation of most new jobs and new wealth. In fact, since the early 1980s, during which time America weathered three recessions, nearly all net new jobs created came from firms less than five years old.

So, to bring a quick end to this recession, the best thing the United States can do is get out of the way of the entrepreneur. If government must act, it should make entrepreneurship more attractive and more viable for more Americans. It could relieve new start-up businesses of some of the tax burdens they face at the state and local level. It might relax labor rules for new firms for the first few years. It could create an expanded program of wage insurance for displaced workers. (Such a system would create a stronger incentive for finding work than the current system of unemployment benefits and, from the entrepreneur’s perspective, might boost the velocity of workers eager to augment their skills or learn new ones on the job.)

Finally, government could lower immigration barriers for highly skilled workers so that some of the brightest engineers and innovators in Japan and elsewhere could come to the U.S. and help us show the world that entrepreneurial capitalism – American style – is worth a second look.

Sen. Clinton’s speech and the mortgage industry report, coming within days of each other, illustrate the two separate and often mutually exclusive tracks that the discussion of the subprime crisis is taking these days. On the one hand, remedies proposed separately by Senators Clinton and Obama, as well as the bailout package agreed to by both Republicans and Democrats in Congress last week, essentially treat many subprime borrowers as victims of seedy mortgage brokers, opportunistic lenders and aggressive Wall Street houses. Under this narrative many borrowers were ‘lured” (in a term used by both Sen. Obama and the New York Times) into mortgages they couldn’t afford, and the Bush administration’s rescue plan--which involves urging borrowers and lenders to work out new loan terms individually--amounts to too little help at too laborious a pace to make a difference.

And yet the more time that passes the clearer we begin to see the extent to which many borrowers themselves may have participated in creating the mess from which we are preparing to rescue them. As more mortgages go bad and enter foreclosure, their details are coming under scrutiny, and the facts are not always pretty. They suggest that while lenders became too careless and some brokers were clearly swindlers, many borrowers were more than simply naïve or overly optimistic; a good many were probably cheating. Any federal legislation package that provides the financing to rework millions of thousands of subprime mortgages quickly is likely to reward quite a few of these chiselers.

One place to look for the cheating is in the speculation which helped drive the market, and which has played so large a role in today’s rising default volume. Everyone, of course, decries speculators, and it’s de rigueur in any speech or editorial endorsing giant bailout packages to denounce these gamblers and exclude them from any help. But as more mortgages unwind, we’re discovering that not only was speculation more rampant than we thought, but that many of these gamblers were deceiving lenders and builders by hiding their intentions.

So-called ‘occupancy fraud’—in which a speculator claims he will live in a house he is buying when it is actually a property he is purchasing for investment purposes-- accounted for about 20 percent of all mortgage swindles during the go-go years of subprime lending, according to a study by BasePoint Analytics, which specializes in detecting mortgage fraud. Buyers hid their intentions because lenders generally require bigger down payments on purchases of investment properties, and some builders will limit the number of investors they allow into a new development, because these buyers are more likely to walk away from a property when the market tanks. Home builders in hot markets were especially susceptible to this fraud because investors would purchase houses in new developments with the intent of flipping them as soon as they were ready to be occupied. Several builders told the Wall Street Journal earlier this year that while they thought that only 10 percent of their sales were to investors in recent years, in fact, it now appears that as many as a quarter of their homes were being snapped up by speculators, who often lied about their intent even when builders required them to sign documents affirming they would reside in their homes.

The level of occupancy fraud is significant because it suggests that speculation accounts for a larger part of the troubled mortgage market than most people realize. For one thing, some of the country’s highest foreclosure rates are in states which until recently had a hot, investor-driven housing market, notably California, Nevada and Florida. In fact, among the five states with the highest rates of foreclosures, defaults by known speculators (that is, those who admitted they were buying investment properties) account for more than one-fifth of all mortgages going bad. We don’t know exactly how many additional defaults can be attributed to occupancy fraud, but some studies have suggested the misrepresentations were widespread. Fitch Ratings, for instance, looked at a portfolio of 45 subprime loans that defaulted within their first year and found that in two-thirds of the cases borrowers never occupied the property, though they said they intended to.

Mortgage fraud, however, doesn’t stop at cheating by investors. There’s evidence that a wide range of borrowers, many probably aided by unsavory brokers, were using inaccurate data and phony documents to purchase homes they otherwise couldn’t afford, and hoping that a rising housing market would keep the deception from coming back to hurt them. One measure of the possible extent of the fraud: BasePoint Analytics took a look at millions of subprime loans and found that in 70 percent of cases where mortgages go bad quickly (exactly the kinds of mortgages that account for a chunk of today’s rising default rates), there was some misrepresentation by the borrower, broker or appraiser, or some combination of the three. Those loans were five times more likely to default quickly than mortgages without falsifications.

One area of particular abuse was so-called ‘stated income’ loans which require little or no documentation of a borrower’s earnings. Originally designed to help self-employed borrowers who don’t have ready access to documents like W-2 forms, no-doc loans became widespread during the height of the real estate boom because lenders naively believed that borrowers wouldn’t lie about income to qualify for loans that they couldn’t afford to pay back. But as soaring housing values made it possible for homeowners to refinance out of unaffordable mortgages using their new homes’ rising equity, lying on no-doc loans became common. One lender which compared 100 stated income loans with IRS data found that in 60 percent of cases, the income that borrowers claimed exceeded their actual earnings by 50 percent or more. BasePoint found in its study that some applications exaggerated income by as much as 500 percent.

Housing advocates, some politicians and journalists have tried to portray borrowers with misrepresentations on their loans as victims rather than cheaters, people put into mortgages they couldn’t afford by dishonest mortgage brokers. But many of these borrowers were irresponsible at best, and complicit at worse. Many apparently sought ‘guidance’ from brokers in to how to tailor their personal details to qualify for mortgages they were seeking, and some merely turned over their applications to brokers and allowed them to fill in the details. In one illustrative case described by an Associated Press story, for instance, a woman who understood that she couldn’t afford a loan for a house was told by a broker that she could rent the property to make ends meet. She went ahead on that basis but couldn’t find a renter and defaulted because her income wasn’t sufficient to pay off the loan. She now claims she was victimized by the broker’s bad advice and by inaccuracies on her application that someone, not her, filled out. How did the inaccuracies get there? She merely signed a blank application and gave it to her broker to fill out, she says, with little concern for the accuracy of the data to be added to the documents she signed.

Untangling the true blame in such cases is going to be nearly impossible, but including such borrowers in government bailouts—as advocates and some politicians have urged--will make it hard to exclude just about anyone whose mortgage applications included misrepresentations.

One thing which suggests that many borrowers were in on the scam is the proliferation of services and websites designed to help people cheat on their applications. During the height of the frenzy borrowers could purchase a higher credit score by paying to attach their names to the accounts of people with better credit. Some services would, for a fee, issue check stubs to provide phony employment verification, and for an extra $25, even give over-the-phone employment verification to any lender checking on an applicant. Some websites even offered to set up phony bank accounts in an applicant’s name and fill them temporarily with real assets to provide phony proof to lenders that the applicant had cash on hand for a down payment.

Many borrowers who used such techniques could be bailed out by some of the large government aid packages currently being discussed, such as the proposal to allow subprime borrowers to refinance into government backed loans, which would essentially bury any misrepresentations in new, more affordable, “cleaner’’ loans. That prospect has prompted the Bush administration, as well as likely GOP presidential nominee John McCain, to temper their enthusiasm for some of the larger bailout plans being discussed.

But many of those advocating a massive government bailout of subprime borrowers now argue that such a move is necessary, even if it rewards some of the ‘undeserving.’ The threat to our economy is so deep and broad that the housing market must be saved, they argue, even if the unworthy are rewarded. Yet geographically the foreclosure crisis remains concentrated in a few places where speculation was rampant, like California and Florida, and is hardly a threat in many other places. Those two states alone accounted for 36 percent of all subprime adjustable rate mortgages that went into foreclosure in the fourth quarter of 2007, because that’s where much of the risky lending was taking place.

It’s common now when discussing the subprime mortgage crisis to talk about the frenzy that drove the market at its height. The question is to what extent ‘frenzy’ is now becoming an acceptable synonym for ‘fraud’.

Commenting on executive compensation to Reuter’s on Monday, Holtz-Eakin declaimed that, "Job No. 1 of the president is to use the bully pulpit to shine a light on behavior that is less-than-exemplary," and when asked about executive pay, he said, “That’s certainly the case here.”

According to Reuters, Holtz-Eakin said McCain would like to see shareholders and company boards take action to make sure “that pay packages for CEOs are reasonable and in line with performance.” And in a speech on Sunday, McCain joined the executive-bashing echo chamber when he blasted the “outrageous” and “unconscionable” compensation of Bear Stearns and Countrywide executives, along with their “co-conspirators” on corporate boards. Holtz-Eakin and McCain miss the point on numerous levels.

For one, companies serve at the pleasure of shareholders, not the president. As such, companies should be allowed to make decisions when it comes to pay in either transparent or opaque fashion; the decision ultimately an economic one relating to what attracts investors. Importantly, investors are free to sell shares in companies that tend toward opacity or that compensate in ways they don’t approve.

Secondly, as investors have found over the years, top management is priceless. While Michael Eisner, Jack Welch and the late Roberto Gouizueta respectively left Disney, GE and Coca-Cola as billionaires, one would be hard pressed to find a shareholder who objected given how the shares of each company strongly outperformed the S&P 500 during their tenures. More modern evidence supporting the idea of the importance of CEOs comes from the rally in Starbucks’ shares after Howard Schultz resumed there as CEO, not to mention the 5.3 percent jump in the market cap of Merrill Lynch on the day that John Thain’s arrival as CEO was announced. It is because top executives can have such a positive impact on companies that their pay is so high, but the process is not foolproof. If it were easy, investing would be easy.

Thirdly, for Holtz-Eakin and McCain to assume that shareholders and company boards can know in advance whether pay packages might be “reasonable” defies common sense. The world of sports offers up myriad examples here in that ahead of the 1998 NFL Draft, many GMs had future bust Ryan Leaf rated ahead of future Hall of Famer Peyton Manning. Back in 1984, Sam Bowie was drafted before Michael Jordan. Former Home Depot CEO Bob Nardelli’s pay package would likely fall into the category of what Holtz-Eakin and McCain would deem “less-than-exemplary” corporate activity, but he was able to command it because he was heavily in demand by numerous corporate boards hopeful that some of his GE magic would rub off on the companies they served.

If we’re willing to ignore the views on executive pay, it would be very difficult to brush off Holtz-Eakin’s comments to U.S. News’ James Pethokoukis last week. It’s what he did not say, and what he did not seem to understand that should have those who think McCain will be good on tax policy a little bit worried.

To be fair, when asked by Pethokoukis about the economic boom under Bill Clinton, Holtz-Eakin said, “The economy survived higher taxes—that doesn't mean the higher taxes caused it. I am sure it was not true, and it doesn't mean the higher taxes were a good idea.” He also noted the positive impact of lower taxes and deregulation in the ‘80s.

But in discussing U.S. productivity over the last few decades, he observed that it disappeared in the ‘70s, and “no one knew why.” There lies the concern. It seems pretty obvious what caused productivity to fall in the ‘70s, and it had to do with a top tax rate of 70 percent that was made even more confiscatory by a falling dollar; the latter a productivity killer for driving a great deal of capital away from the innovative economy into real assets such as gold, housing and art. Shades of today?

Holtz-Eakin also failed to mention that until 1969, the top rate on capital gains taxes was 25 percent. In '69 Congress raised the minimum rate on investment success to 50 percent, and as Bruce Bartlett pointed out in his 1981 book Reaganomics, the “effect of this tax change was immediate and dramatic.” Indeed, with productivity-enhancing companies heavily reliant on capital, the new capital gains rate caused the annual number of IPOs to fall from a high of 1,298 in 1969 all the way to a low of eighteen in 1978. New companies raised $3.5 billion in 1969, but with capital taking safe haven from inflation and a 50 percent investment-success penalty, by 1978 a measly $54 million was raised.

When we consider Holtz-Eakin’s positive comments about the ‘80s tax cuts, to some degree we can say this is a basic and shrewd political calculation to talk up the Reagan era. In short, Republicans traditionally run on tax-cutting platforms, while Democrats campaign for tax increases.

More crucial is a core understanding of why economies soften, particularly in the present environment when so many assume we’re either in or headed for a recession. For Holtz-Eakin to pass off the 1970s economic failures as mysterious along the lines of sunspots or draughts speaks volumes. He should know exactly why the economy underperformed in the ‘70s, because in understanding that failure, he would be able to help McCain articulate the need for the marginal tax cuts and improved dollar policy that will help us emerge from today’s “1970’s-lite.”

So when we contemplate a John McCain presidency, we have to ask whether his beliefs match the kind of rhetoric we’d expect from any successful GOP candidate. The commentary coming from his top economic advisor suggests the more optimistic among us might be disappointed. Just like the man he serves, Holtz-Eakin doesn’t seem quite on board with why tax cuts are so effective. That being the case, McCain partisans should hope for a lot more Steve Forbes on the campaign trail, and a lot less Douglas Holtz-Eakin.

It used to be thought that wars were good for the economy. After all, World War II is widely thought to have helped lift the global economy out of the Great Depression. But, at least since Keynes, we know how to stimulate the economy more effectively, and in ways that increase long-term productivity and enhance living standards.

This war, in particular, has not been good for the economy, for three reasons. First, it has contributed to rising oil prices. When the United States went to war, oil cost less than $25 a barrel, and futures markets expected it to remain there for a decade. Futures traders knew about the growth of China and other emerging markets; but they expected supply – mainly from low-cost Middle East providers – to increase in tandem with demand.

The war changed that equation. Higher oil prices mean that Americans (and Europeans and Japanese) are paying hundreds of millions of dollars to Middle East oil dictators and oil exporters elsewhere in the world rather than spending it at home.

Moreover, money spent on the Iraq war does not stimulate the economy today as much as money spent at home on roads, hospitals, or schools, and it doesn’t contribute as much to long-term growth. Economists talk about “bang for the buck” – how much economic stimulus is provided by each dollar of spending. It’s hard to imagine less bang than from bucks spent on a Nepalese contractor working in Iraq.

With so many dollars going abroad, the American economy should have been in a much weaker shape than it appeared. But, much as the Bush administration tried to hide the true costs of the war by incomplete and misleading accounting, the economy’s flaws were covered up by a flood of liquidity from the Federal Reserve and by lax financial regulation.

So much money was pumped into the economy and so lax were regulators that one leading American bank advertised its loans with the slogan “qualified at birth” – a clear indication that there were, in effect, no credit standards. In a sense, the strategy worked: a housing bubble fed a consumption boom, as savings rates plummeted to zero. The economic weaknesses were simply being postponed to some future date; the Bush administration hoped that the day of reckoning would come after November 2008. Instead, things began to unravel in August 2007.

Now it has responded, with a stimulus package that is too little, too late, and badly designed. To see the inadequacy of that package, compare it with the more than $1.5 trillion that was borrowed in home equity loans in recent years, most of it spent on consumption. That game – based on a belief in ever-spiraling home prices – is over.

With home prices falling (and set to continue to fall), and with banks uncertain of their financial position, lenders will not lend and households will not borrow. So, while the additional liquidity injected into the financial system by the Fed may have prevented a meltdown, it won’t stimulate much consumption or investment. Instead, much of it will find its way abroad. China, for example, is worried that the Fed’s stimulus will increase its domestic inflation.

There is a third reason that this war is economically bad for America. Not only has America already spent a great deal on this war – $12 billion a month, and counting – but much of the bill remains to be paid, such as compensation and health care for the 40% of veterans who are returning with disabilities, many of which are very serious.

Moreover, this war has been funded differently from any other war in America’s history –perhaps in any country’s recent history. Normally, countries ask for shared sacrifice, as they ask their young men and women to risk their lives. Taxes are raised. There is a discussion of how much of the burden to pass on to future generations. In this war, there was no such discussion. When America went to war, there was a deficit. Yet remarkably, Bush asked for, and got, a reckless tax cut for the rich. That means that every dollar of war spending has in effect been borrowed.

For the first time since the Revolutionary War, two centuries ago, America has had to turn to foreigners for financing, because US households have been saving nothing . The numbers are hard to believe. The national debt has increased by 50% in eight years, with almost $1 trillion of this increase due to the war – an amount likely to more than double within ten years.

Who would have believed that one administration could do so much damage so quickly? America, and the world, will be paying to repair it for decades to come.

Joseph E. Stiglitz, Professor of Economics at Columbia University, received the Nobel Prize in economics in 2001. His most recent book, co-authored with Linda Bilmes, is The Three Trillion Dollar War: The True Costs of the Iraq Conflict. Copyright: Project Syndicate, 2008.

What factors determine the size of trade flows between countries? Trade theory suggests that comparative advantage and resource endowments explain why countries trade and what they trade, but these models have less to say about how other factors influence the total volume of trade between countries. To measure bilateral trade flows, policy analysts often employ “gravity models,” which suggest that “mass” (usually proxied by GDP) ought to increase trade flows while distance ought to decrease them. Additional economic and geographic variables are usually included to account for specific characteristics of countries that also may influence trade flows. More recently, researchers have augmented the basic gravity model with political and institutional variables in order to better understand how factors such as currency unions, tariffs, wars, and exchange-rate regimes affect trade flows between countries.

Studies examining the effects of currency unions on trade, and more specifically the effects of the Eurozone on trade among its members, are leading examples of the new emphasis on understanding how institutions affect trade. Advocates of the euro suggest that a single currency boosts trade among members of the Eurozone by reducing uncertainty over exchange-rate movements, by lowering transactions costs, and by spurring competition. While noting that there are costs to adopting the euro (such as the freedom to deviate from the ECB’s interest-rate path), policymakers who favour the new monetary arrangement point to the growth in trade among constituent members as one reason why it ought to be maintained. To date, there is little agreement on the precise impact of the Euro on trade, but recent estimates suggest that it may have boosted average trade by roughly 5 to 10 percent within the Eurozone (Baldwin, 2006).

Other types of political relationships also have the potential to influence trade flows. For example, many of the studies that report on the salutary effects of currency unions also provide evidence that a country’s prior colonial status exerts a large and statistically significant positive effect on current bilateral trade. This finding raises several interesting questions, including whether extant empires boost contemporaneous trade, and if so, how they operate to influence trade. Although formal empires declined during the twentieth century, the changing geopolitics of the 21st century and the continued underperformance of sub-Saharan African countries have reignited interest in understanding how earlier empires and colonial relationships affect economic outcomes (Ferguson 2004; Lal 2001, 2004; Acemoglu, Johnson, and Robinson, 2001).

The Age of High Imperialism

Examining the Age of High Imperialism (1870-1913) helps to shed light on how political relationships can come to dominate trade flows. The late nineteenth and early twentieth centuries are often referred to as the first era of globalization, and provide a nice benchmark for comparison with the modern period since the earlier period was also characterized by durable monetary arrangements (the gold standard) and currency unions (the Latin and Scandinavian Monetary Unions). But the dominant political feature that dictated both trade and financial flows during the earlier period of globalization was empire.

Even though the British Empire, which spanned five continents, was still unrivalled during the 19th century, continental European countries began to more actively challenge Britain’s role on the world stage in the latter half of the century. New imperial powers sought overseas territories to complement their growing economies, which had been stimulated by the industrial revolution. Colonial acquisitions during this phase of expansion included Britain extending its holdings in Burma, Malaysia, and Africa, France consolidating its Indo-Chinese Empire and its foothold in Madagascar, and Germany carving out an empire in Africa. The Age of High Imperialism also included the United States, which had acquired the Philippines and Hawaii after its war with Spain.

The notion that trade and empire are linked is certainly not new. Scholarly debate reaches back over a century, but few studies have attempted to measure the effects. Recent research based on a large, new database of over 21,000 bilateral trade pairs from the Age of High Imperialism finds that, on average, being in an empire more than doubled trade, even after controlling for a variety of standard economic and geographic influences (Mitchener and Weidenmier, 2007). The study also suggests that the contemporaneous effects of empire on trade were larger than the effects of either non-empire currency unions or the gold standard – the largest currency arrangement in history – and significant enough in size to overcome the tyranny of distance.

Although there are many possible ways in which a particular colony’s trade was affected by being in a nineteenth or early-twentieth century empire, trade policies and lower transactions costs appear to be important in explaining why being in an empire boosted trade. Like tariffs and regional free trade agreements today, imperial trade policies of a century ago strongly influenced trade flows. In particular, preferential trade agreements (which were designed by colonies and metropoles to set higher rates on non-empire goods and were used by the Portuguese, American, Spanish Empires and British Dominions), as well as customs unions within empires (employed by France and many of its colonies) significantly boosted the flow of trade within empires.

Empires also lowered transactions costs and payments frictions by promoting a common language among merchants (a lingua franca), creating familiarity with local customs and culture, and encouraging the development of distribution and marketing channels and the formation of social networks. As with the euro today, the role of “vehicle currencies” and currency unions was central to lowering the transaction costs associated with trade. In the empires of last century, transactions costs declined significantly due to the widespread propagation and use of colonial currencies. The United States introduced the dollar in its dependencies after acquiring many of its colonies in the Spanish-American War of 1898. British and German colonies joined the sterling and mark blocks or formed currency unions with other colonies in the region. British colonies in East Africa, for example, formed a silver rupee union with India that also included some areas in East Africa that were members of the German Empire. The large increase in trade flows due to empire-based currency unions may have been especially pronounced during the first era of globalization since many colonies, especially in Africa, had largely conducted trade through barter. When the economies became monetized as a result of colonization and the introduction of colonial currencies, trade rose in response to the benefits that accrued from having a standard unit of account and medium of exchange.

Tariffs, currency unions, free trade areas, and empires hinge on the commitments of rulers and policymakers to maintain their existence. Even after these commitments are abandoned, such institutions can continue to exert influence over economic outcomes. The research on trade points to the complexities in understanding the legacies of institutions. Research suggests that prior colonial status still boosts bilateral trade today. In the classical economics tradition, some researchers view these larger trade flows as welfare enhancing, while others point to the potential pitfalls of “locking” ex-colonies into long-run trade patterns that are sub-optimal and potentially counterproductive for economic development. Other researchers focus on the relationship between institutions, trade, and economic development. Some suggest that settler colonies, in particular, may have benefitted from the trade and openness that the British Empire promoted; trade may have left institutions that fostered greater economic development and growth as a result. On the other hand, European empires may have undermined long-run productivity and growth in other colonies by leaving extractive institutions that did not introduce protections for private property or restrain governments from expropriation (Acemoglu, Johnson, and Robinson, 2001). While empires appear to have increased trade flows then and now, in creating the machinery for trade, empires also imparted institutions that had ambiguous effects on economic growth and development.

Kris James Mitchener is an Assistant Professor of Economics at Santa Clara University.

References

Acemoglu, Daron, Simon Johnson, and James Robinson. (2001). “The Colonial Origins of Comparative Development: An Empirical Investigation.” American Economic Review 91(5):1369-1401.

Baldwin, Richard. (2006). “The Euro’s Trade Effects” European Central Bank Working Paper 594 (March).

Ferguson, Niall. (2004). Colossus: The Price of American Empire. New York: Penguin Press.

Lal, Deepak. (2004). In Praise of Empires: Globalization and Order. New York: Palgrave Macmillan.

Mitchener, Kris James and Marc Weidenmier. “Trade and Empire.” Economic Journal (Forthcoming) and NBER Working Paper 13765.

What factors determine the size of trade flows between countries? Trade theory suggests that comparative advantage and resource endowments explain why countries trade and what they trade, but these models have less to say about how other factors influence the total volume of trade between countries. To measure bilateral trade flows, policy analysts often employ “gravity models,” which suggest that “mass” (usually proxied by GDP) ought to increase trade flows while distance ought to decrease them. Additional economic and geographic variables are usually included to account for specific characteristics of countries that also may influence trade flows. More recently, researchers have augmented the basic gravity model with political and institutional variables in order to better understand how factors such as currency unions, tariffs, wars, and exchange-rate regimes affect trade flows between countries.

Studies examining the effects of currency unions on trade, and more specifically the effects of the Eurozone on trade among its members, are leading examples of the new emphasis on understanding how institutions affect trade. Advocates of the euro suggest that a single currency boosts trade among members of the Eurozone by reducing uncertainty over exchange-rate movements, by lowering transactions costs, and by spurring competition. While noting that there are costs to adopting the euro (such as the freedom to deviate from the ECB’s interest-rate path), policymakers who favour the new monetary arrangement point to the growth in trade among constituent members as one reason why it ought to be maintained. To date, there is little agreement on the precise impact of the Euro on trade, but recent estimates suggest that it may have boosted average trade by roughly 5 to 10 percent within the Eurozone (Baldwin, 2006).

Other types of political relationships also have the potential to influence trade flows. For example, many of the studies that report on the salutary effects of currency unions also provide evidence that a country’s prior colonial status exerts a large and statistically significant positive effect on current bilateral trade. This finding raises several interesting questions, including whether extant empires boost contemporaneous trade, and if so, how they operate to influence trade. Although formal empires declined during the twentieth century, the changing geopolitics of the 21st century and the continued underperformance of sub-Saharan African countries have reignited interest in understanding how earlier empires and colonial relationships affect economic outcomes (Ferguson 2004; Lal 2001, 2004; Acemoglu, Johnson, and Robinson, 2001).

The Age of High Imperialism

Examining the Age of High Imperialism (1870-1913) helps to shed light on how political relationships can come to dominate trade flows. The late nineteenth and early twentieth centuries are often referred to as the first era of globalization, and provide a nice benchmark for comparison with the modern period since the earlier period was also characterized by durable monetary arrangements (the gold standard) and currency unions (the Latin and Scandinavian Monetary Unions). But the dominant political feature that dictated both trade and financial flows during the earlier period of globalization was empire.

Even though the British Empire, which spanned five continents, was still unrivalled during the 19th century, continental European countries began to more actively challenge Britain’s role on the world stage in the latter half of the century. New imperial powers sought overseas territories to complement their growing economies, which had been stimulated by the industrial revolution. Colonial acquisitions during this phase of expansion included Britain extending its holdings in Burma, Malaysia, and Africa, France consolidating its Indo-Chinese Empire and its foothold in Madagascar, and Germany carving out an empire in Africa. The Age of High Imperialism also included the United States, which had acquired the Philippines and Hawaii after its war with Spain.

The notion that trade and empire are linked is certainly not new. Scholarly debate reaches back over a century, but few studies have attempted to measure the effects. Recent research based on a large, new database of over 21,000 bilateral trade pairs from the Age of High Imperialism finds that, on average, being in an empire more than doubled trade, even after controlling for a variety of standard economic and geographic influences (Mitchener and Weidenmier, 2007). The study also suggests that the contemporaneous effects of empire on trade were larger than the effects of either non-empire currency unions or the gold standard – the largest currency arrangement in history – and significant enough in size to overcome the tyranny of distance.

Although there are many possible ways in which a particular colony’s trade was affected by being in a nineteenth or early-twentieth century empire, trade policies and lower transactions costs appear to be important in explaining why being in an empire boosted trade. Like tariffs and regional free trade agreements today, imperial trade policies of a century ago strongly influenced trade flows. In particular, preferential trade agreements (which were designed by colonies and metropoles to set higher rates on non-empire goods and were used by the Portuguese, American, Spanish Empires and British Dominions), as well as customs unions within empires (employed by France and many of its colonies) significantly boosted the flow of trade within empires.

Empires also lowered transactions costs and payments frictions by promoting a common language among merchants (a lingua franca), creating familiarity with local customs and culture, and encouraging the development of distribution and marketing channels and the formation of social networks. As with the euro today, the role of “vehicle currencies” and currency unions was central to lowering the transaction costs associated with trade. In the empires of last century, transactions costs declined significantly due to the widespread propagation and use of colonial currencies. The United States introduced the dollar in its dependencies after acquiring many of its colonies in the Spanish-American War of 1898. British and German colonies joined the sterling and mark blocks or formed currency unions with other colonies in the region. British colonies in East Africa, for example, formed a silver rupee union with India that also included some areas in East Africa that were members of the German Empire. The large increase in trade flows due to empire-based currency unions may have been especially pronounced during the first era of globalization since many colonies, especially in Africa, had largely conducted trade through barter. When the economies became monetized as a result of colonization and the introduction of colonial currencies, trade rose in response to the benefits that accrued from having a standard unit of account and medium of exchange.

Tariffs, currency unions, free trade areas, and empires hinge on the commitments of rulers and policymakers to maintain their existence. Even after these commitments are abandoned, such institutions can continue to exert influence over economic outcomes. The research on trade points to the complexities in understanding the legacies of institutions. Research suggests that prior colonial status still boosts bilateral trade today. In the classical economics tradition, some researchers view these larger trade flows as welfare enhancing, while others point to the potential pitfalls of “locking” ex-colonies into long-run trade patterns that are sub-optimal and potentially counterproductive for economic development. Other researchers focus on the relationship between institutions, trade, and economic development. Some suggest that settler colonies, in particular, may have benefitted from the trade and openness that the British Empire promoted; trade may have left institutions that fostered greater economic development and growth as a result. On the other hand, European empires may have undermined long-run productivity and growth in other colonies by leaving extractive institutions that did not introduce protections for private property or restrain governments from expropriation (Acemoglu, Johnson, and Robinson, 2001). While empires appear to have increased trade flows then and now, in creating the machinery for trade, empires also imparted institutions that had ambiguous effects on economic growth and development.

Kris James Mitchener is an Assistant Professor of Economics at Santa Clara University.

References

Acemoglu, Daron, Simon Johnson, and James Robinson. (2001). “The Colonial Origins of Comparative Development: An Empirical Investigation.” American Economic Review 91(5):1369-1401.

Baldwin, Richard. (2006). “The Euro’s Trade Effects” European Central Bank Working Paper 594 (March).

Ferguson, Niall. (2004). Colossus: The Price of American Empire. New York: Penguin Press.

Lal, Deepak. (2004). In Praise of Empires: Globalization and Order. New York: Palgrave Macmillan.

Mitchener, Kris James and Marc Weidenmier. “Trade and Empire.” Economic Journal (Forthcoming) and NBER Working Paper 13765.

For the next dozen years or so the US broad stock markets will be a wild roller-coaster ride. The Dow Jones Industrial Average and the S&P 500 index will go up and down (and in the process will set all-time highs and multiyear lows), stagnate, and trade in a tight range. At some point during the ride, index investors and buy and hold stock collectors will realize that their portfolios aren't showing much of a return.

I know this prediction has a mild sci-fi feel to it. After all, how could I possibly know what the market will do, especially that far into the future? Though I'll explain in more detail in just a second why I have the audacity to make this prediction, let me offer you a little factoid: over the last 200 years, every full-blown, long-lasting (secular) bull market (and we just had a supersized one from 1982 to 2000) was followed by a range-bound market that lasted about 15 years. Yes, this happened every time, with the exception of the Great Depression, over the last two centuries.

Though we tend to think about market cycles in binary terms - bull (rising) or bear (declining) - in the long run markets spend a lot more time in bull or range-bound (sideways) states, roughly half in each, and visit a bear cage a lot less often then we think. This distinction between bear and range-bound markets is extremely important, as you'd invest very differently in one versus the other.

Are bull markets driven by superfast economic growth? Are range-bound markets caused by subpar economic growth? Could the subpar market performance be related to high or low inflation?

The answer to all these questions is undoubtedly - "no." Though it is hard to observe in the everyday noise of the stock market, in the long run stock prices are driven by two factors: earnings growth (or decline) and/or price-to-earnings expansion (or contraction).

As is apparent from Exhibits 1 & 2, either by a decade at a time or a market cycle at a time, it is difficult to find a link between stock performance and the economy (e.g., GDP, corporate earnings growth, or inflation). The connection does exist, but periods of disconnect appear to last for decades at a time.

Exhibit 1

Exhibit 2

What about interest rates? Exhibit 3 shows P/Es for the S&P 500 (based on one-year trailing earnings) and inverse long-term bond yields - the implied P/E - the famous Fed Model. This model, despite its name, is NOT endorsed by the Fed; it indicates the existence of a tight relationship between (inverse of) long-term Treasury bonds and P/Es of the S&P 500.

Exhibit 3

By taking a look at the last full 1966-2000 range-bound/bull market cycle (see Exhibit 3), we can see that the Fed Model perfectly predicted the direction of equities in relation to interest rates (okay, assuming you could predict interest rates). Long-term interest rates were rising from 1966 to 1982, while implied and actual P/Es were falling. Whereas from 1982 to 2000 interest rates were dropping, and implied and actual P/Es were rising. Intellectually that makes sense, because stocks and bonds compete for investors' capital, and thus higher interest rates make equities less attractive and vice versa.

However, it is hard to find ANY relationship between interest rates and the animal with its name on the secular market if you look at the first 66 years of the 20th century. None!

It is difficult to dismiss the role interest rates play in stock valuations, but they seem to be a second fiddle in the orchestra conducted by economic growth and valuation. If the Fed Model worked flawlessly, how could we explain declining P/Es of Japanese stocks in the last decade of the 20th century, when interest rates declined and were scratching zero levels?

It is valuation! If earnings growth in the long run remains consistent with the past, P/E is the wild card that is responsible for future returns. Though continued economic growth appears to be a wildly optimistic assumption given the meltdown of the housing industry in particular, and job layoffs, it is not particularly unrealistic to predict that we will see economic growth overall. With the exception of the Great Depression (see Exhibits 1 & 2), though it had its ups and downs, economic growth was fairly stable throughout the 20th century. Earnings, though more volatile than real GDP, grew consistently decade after decade, paying no attention to the animal (bull, bear ... or cowardly lion - my pet name for range-bound markets, whose bursts of occasional bravery lead to stock appreciation, but which are ultimately overrun by fear that leads to a subsequent descent) lending its name to the stock market.

Though economic fluctuations were responsible for short-term (cyclical) market volatility, as long as economic performance was not far from the average, long-term market cycles were either bull or range-bound. Valuation - the change in price to earnings, its expansion or contraction - was the wild card that was mainly responsible for markets being in a bull or range-bound state.

Market Cycle Math

So let's examine the stock market math for secular bull, range-bound, and bear markets. The following Exhibit 4 shows sources of price appreciation in past bull, range-bound, and bear markets.

Exhibit 4

During bull markets, a vibrant, peaceful combination of P/E expansion (a staple of bull markets, a great source of return) and earnings growth brings outsize returns to jubilant investors. Prolonged bull markets start with below- and end with above-average P/Es.

P/Es are some of the most mean-reverting creatures, and range-bound markets act as clean-up guys: they rid us of the mess (i.e., deflate high P/Es) caused by bull markets, taking them down towards and actually below the mean. P/E compression wipes out most if not all earnings growth, resulting in zero (or nearly) price appreciation plus dividends.

Bear markets are range-bound markets' cousins; they share half of their DNA: high starting valuations. However, where in cowardly lion markets economic growth helps to soften the blow caused by P/E compression, during secular bear markets the economy is not there to help. Economic blues (runaway inflation, severe deflation, subpar or negative economic or earnings growth) add oil to the fire (started by high valuations) and bring devastating returns to investors.

A true secular bear market has not really taken place in the US, but one has occurred across the pond in Japan. The market decline caused by the Great Depression, though referred to as the greatest decline in US stocks in the 20th century, only lasted three years and thus doesn't really fit the traditional "secular" requirement of lasting more than five years. Japan's Nikkei 225 suffered (see Exhibit 5) through a true secular bear market: stock prices declined over 80 percent from their 1989-1991 highs until they bottomed in 2003 (the market seems to be coming back now). For more than a decade the country struggled with deflation caused by its banking system coming to a near halt on the heels of a collapsing real estate market and the bad loans that came with it. Of course, all this took place on the heels of a huge bull market, and thus very high valuations.

Exhibit 5

A unique aspect that contributed to the severity and longevity of the Japanese deflation was a cultural issue: the Japanese government intervened and did not allow structurally defunct companies to go bankrupt, thus tampering with the nucleus of capitalism (and Darwinism as well), creative destruction. I must admit, it seems that lately we've been importing a lot more from Japan than their cars and flat-screen TVs, as the US government steps in to "fix" our troubled financial firms. (In the following articles I argue against government bailing out homeowners and against the Fed bailing out the economy).

Where Are We Today?

Today stocks may appear cheap at first glance, at least if you look at valuations of the late 1990s. They are not! To minimize the impact of cyclical profit volatility, let's first take a look at stock market historical and current valuations, based on 10-year trailing earnings, as shown in Exhibit 6. This way we capture a full economic cycle.

Exhibit 6

The conclusions we can draw are:

• Secular bull markets end at P/Es much above average. The 1982-2000 bull market ended at the highest valuations ever!
• Secular range-bound markets ended when P/Es were below average.
• Markets spent very little time at what is known to be a "fairly valued" state of 15 times 12-month trailing earnings. Historically, stocks only saw average valuations on the way from one extreme to the other. From 1900 to 2006 the S&P 500 spent less than 27% of the time between P/Es of 13 and 17.
• Today, after eight years of plentiful volatility and no returns, what the WSJ called a "lost decade," stocks are not cheap. If you look at ten-year trailing earnings, they are still at levels where previous range-bound markets started. In other words, based on 10-year trailing earnings, stocks are still at 64% above their average stated valuations.

Now, if you look at historical valuations where P/Es are computed based on one-year trailing earnings (see Exhibit 7), the picture is not that exciting but less grim. At about 18 times trailing earnings, US stocks don't appear that expensive.

Exhibit 7

Unfortunately, the cheapness argument falls on its face once you realize that (pretax) profit margins are hovering at an all-time high of 11.5%, about 35% above their historical (since 1980) average of 8.5%. Similarly to P/Es, profit margins are extremely mean-reverting. As companies start to earn above-average economic profits, new competition waltzes in and competes these excess profits away - arrivederci fat profit margins. Once this happens, the "E" in the "P/E" equation will decline as well, and P/Es will rise from 18 to 22. An additional point: as you see in Exhibit 8, margins don't have to revert and stop at the mean; historically they've gone below the mean - that is how the mean is created. (In the February 4th, 2008 issue of Barron's I rebuffed common
arguments against profit-margin mean reversion.)

Exhibit 8

As a side note: The bulk of excesses in overall profit margins, 54.5% to be exact (see Exhibit 9), were in "stuff" stocks (i.e., energy, materials, and industrials). Profit margins will deflate when the global economy slows down. This goes far beyond oil and commodities. Companies that make "stuff," which historically have been very cyclical (today is no different) have benefitted from tremendous operational leverage that contributed to considerable improvement in margins. However, leverage works both ways: lower sales and high fixed costs will push margins to the other extreme.

Exhibit 9

Financials were responsible for 22% of the excess in margins, as they benefitted from tremendous liquidity hosed down by the Fed over recent years; now they are drowning in it. Their margins are compressing at a faster rate than you can read this.

Finally, the "new" economy stocks are responsible for 17% of the excess. However, I'd argue that these industries have transformed substantially since 1988, so that higher-margin software and services now account for a much larger portion of technology and telecom sales. It is kind of like Microsoft (ironically the "new" economy) vs. IBM in 1988: the hardware company (the old economy) vs. the new. Of course IBM of today is lot more of a software and service company than the hardware company it was in the 1980s. Thus the "new" economy stocks should have higher margins than they did in 1988, but by how much? I don't know, but they likely will face a lower margin compression than "stuff" and financials.

The bottom line: Remember those long-term double-digit returns you were promised by stock market gurus during the last bull market? Well, an average passive buy-and-hold investor will be lucky to have very low single-digit returns for the long term. In fact, during the last 1966-1982 range-bound market, investors received almost zero real total returns.

Analyze and Strategize

Fairly depressing stuff, and it sounds like the investor is going to have to eat lower returns. However, there are strategies to improve portfolio performance so that one can do well, even in a trading range. Whether you are a buy-and-hold or stalwart value investor, there are opportunities that don't require you to day trade stocks. You don't have to change your investment philosophy, but you have to tweak your stock analysis and strategy a little to adapt it to range-bound markets.

Modify your analysis: To clarify, I created an analytical framework where stock analysis is broken down into three dimensions: Quality, Valuation, and Growth.

Quality. Though often it is in the eye of the beholder, in my book I clarify what constitutes a quality company (i.e., sustainable competitive advantage, strong balance sheet, great management, high return on capital, and a lot more). But the lesson here is, you want to compromise as little as possible on this dimension, because it is very difficult to recover from significant losses in the range-bound market. Stick to quality.

Growth. This dimension consists of earnings (cash flows), growth, and dividends. When you own companies that grow earnings, time is on your side. Dividends are extremely important in range-bound markets, in fact 90% of the returns in past range-bound markets came from dividends, vs. less than 20% in past bull markets. Also, today an average stock (i.e., S&P 500 index) yields only 1.7%. Do you really want 1.7% to be 90% of your total return?

Valuation. This dimension requires the most modification: the valuations that we saw in the 1982-2000 bull market are not coming back anytime soon, but don't step into what I call the relative valuation trap. Don't buy stocks based solely on their relative cheapness to their prices in the past, but rather based on what their future cash flows will bring. To combat a constant P/E compression, in the range-bound market increase your required margin of safety.

That value (i.e., low P/E stocks) beats growth (high-valuation stocks that have high expectations built in) has been historically documented by numerous studies. After doing extensive study of the 1966-1982 range-bound market, I found that value kills growth. Cheaper stocks had a lower P/E compression and generated bull-market-like returns, plus they had a natural advantage: their lower P/Es led to higher dividend yields. Stock selection matters in the range-bound market. Blindly throwing money at market indices - a strategy that did wonders in the past bull market - will bring market-like returns, which likely will not pay for your dream house or fund your retirement.

Strategize: Once you have determined, based on the Quality, Valuation, and Growth framework, what stocks are to be bought and at what prices, you can start applying a range-bound market strategy.

A long-lasting secular range-bound market consists of many mini (months to several years long) cycles. For instance, the last 1966-1982 range-bound market consisted of five mini bull, five bear, and one range-bound market (See Exhibit 10).

Exhibit 10

Successful investing is a lonely place, as it requires an independent thought process that often goes contrary to the herd mentality. In the range-bound market, a contrarian mindset comes in especially handy, as you'll be selling when everyone else is buying. Your stocks will be hitting their fair value, and you'll be buying when everyone else is selling - during the mini bear markets.

This is not to suggest that you need to be a market timer, not at all. Market timing only looks easy with the benefit of hindsight, and it is very difficult to do on a consistent basis. Instead, time (price) individual stocks, one at a time. Buy when they are undervalued and sell when they are fairly valued, and repeat the process over and over again. In other words, instead of focusing on the bowling alley (the market) focus on the ball (individual stocks).

Selling is looked upon as a four-letter word, and therefore a sin, in a bull market. A buy-and-hold strategy (which is often just buy and forget to sell) is rewarded richly in secular bull markets - every time you made a "don't sell" decision, stocks go higher. And though buy and hold is not dead but in a coma (waiting for the next bull market), it takes investors to a place of no returns. Forgive yourself the "sin" of selling and become a buy-and-sell investor.

The almighty US constitutes 4% of the world population, but its stock market capitalization represents more than a third of the world's wealth. It has been comfortable for us to buy US stocks; it felt safe. However, by solely focusing on US stocks we are insulating ourselves from a greater pool of stocks to choose from. You don't need to become an Indiana Jones of international investing by venturing into fourth-world countries like South Paragama or Liberania (ok, I made those up, didn't want to offend folks in Turkmenistan or some other places heading towards the stone age), but there are plenty of countries that have a stable political regime and the rule of law.

I could be wrong but I doubt it

What if I am wrong and the range-bound market I describe is not in the cards? After all, history is prolific about the past but mute about the future. What if they find life on Venus and our economy starts growing at double digits and the secular bull market thunders upon us? Or the current credit market problems spill into a Japanese-like prolonged recession, causing a bear market? Every strategy should be evaluated not just on a "benefit of being right" basis, but at least as importantly on a "cost of being wrong" basis. An active value-investing strategy has the lowest cost of being wrong in comparison to other investment strategies, as you'll see in Exhibit 11.

Exhibit 11

Reading all of this after having filed your taxes, you probably imagine that the rich are doing a nifty job of avoiding theirs, and that it’s an overburdened middle class that is mostly supporting America’s government—from the war in Iraq to our many domestic programs. And you’d be wrong. As Internal Revenue Service data demonstrate, the rich are getting wealthier, but they are also paying a steadily increasing share of the federal tax burden. Over 25 years, in fact, the percentage of the federal income tax bill paid by the wealthiest Americans has doubled, even as it has shrunk for all others. We are rapidly becoming a society in which a very few pay the greatest part of the cost of government, and everyone else enjoys the benefits. And many people, from our Democratic presidential candidates to members of Congress, want to make it even more so.

To consider how the landscape has changed, it’s worth looking at taxes paid by various income groups over time, via data crunched by the IRS. In 1980, with Jimmy Carter still as president, the top 1 percent of filers, those who reported an adjusted growth income of $80,580 or more, paid 19 percent of all federal income taxes. That was actually less than the total tax share of people collectively in the 11th to 25th percentiles, that is, middle income taxpayers making roughly between $24,000 and $35,000 (in 1980 dollars), and also less than the total share of those earning between $13,000 and $24,000, who represented the 26th to 50th percentiles.

A decade later, despite tax cuts in the 1980s that many critics claimed benefited the rich, our top 1 percent of filers were paying more of the total--25 percent of the country’s tax bill—than anyone else. The portion of taxes paid by the top filers continue to grow throughout the 1990s and into the new century, pausing only for recessions, which are generally periods in which the share of taxes paid by the rich falls because their incomes tend to decline the most. By 2005, the most recent year data are available, our top 1 percent of filers were paying nearly 40 percent of the federal income tax bill, while those in the 2nd to 5th percentile paid another 20 percent. Every other group saw its share of the tax bill decline, sometimes substantially. Those taxpayers in the 26th to 50th percentile (that is, with an adjusted gross income roughly between $31,000 and $62,000) paid 11 percent of all federal income taxes, down from 20 percent back in 1980, while those in the 11th to 25th percentiles (earning between $62,000 and $104,000 today), paid 16 percent of the federal tax bill, down from 24 percent in 1980.

How can all of this be true if, to hear Warren Buffett tell his story, it’s so easy for the rich to minimize their taxes? Buffett’s claim, based on comparing his tax rate to those of people who worked for him, got plenty of publicity, and probably invoked in many people the memory of Leona Helmsley’s infamous line, “only the little people pay taxes.” Buffett’s low tax rate, some people conjectured, was a result of the fact that he earned mostly dividend and capital gains income, and those are now taxed largely at a 15 percent rate.

But Buffett is an exception—one of the super rich. By contrast, most of the wealthy in America today garner their income principally from wages, and thus not only pay more in taxes, but pay taxes at a higher real rate than everyone else—Warren Buffett aside. While taxpayers in every bracket do what they can to minimize their taxes, in 2005, the top 1 percent of filers paid 23 percent of their adjusted gross income in income taxes. Those earning between $62,000 and $104,000--certainly part of the middle class that Hillary Clinton says is bearing a bigger burden because of tax cuts for the wealthy--paid an average tax rate of 9 percent. The tax rate of those with incomes between $31,000 and $62,000 was under 7 percent, or less than one third of the tax rate of the rich.

Of course, this is only the federal income tax. We have other taxes in America, including payroll taxes and even corporate taxes—which individuals pay indirectly through taxes on businesses in which we own shares. The Congressional Budget Office, a nonpartisan entity like the IRS, figures all of those into its calculations of tax rates that Americans pay and concludes that the richest 1 percent pay an even higher real tax rate than the IRS figures—31 percent of income.

Yes, these stats do tell us that some people are doing very well in America, including presumably many people who were middle or low-income workers sometime during the past 25 years and have now vaulted into the top 1 percent of earners. But the data also tell us that much of the hyperventilating in our public discussions about the rich not paying a fair share of taxes is disconnected from reality.

Still, given how skewed the discussion has become, it seems almost certain that with a Democratic victory in the presidential race come November, we will see taxes—and the overall share of taxes paid--rise for the wealthy. Are there any dangers in a society where a fleetingly few earners pay such a big share of taxes, and where some folks’ notion of fairness means taxing these few ever more? We might consider that question by looking at states with their own progressive state income taxes.

Last week, for instance, a labor union-supported policy group released a study noting that Connecticut now has the largest gap between the rich and the poor in the nation. The local pages of the New York Times dutifully reported on this study and asked, what could be done as a remedy? Raise taxes, the advocates urged, heedless of the fact that in Connecticut the top 5 percent of the state’s taxpayers already bear the bulk of the state’s income tax burden. The situation is much the same in neighboring New Jersey and in New York where, for instance, the top income bracket represents just 0.4 percent of taxpayers, but they pay one-third of the state’s income tax.

Is there a consequence to this? Well, for one thing, it’s practically compulsory when talking about the state government in each of these three places to use the adjective “dysfunctional.” All three states have seen governors resign in disgrace within the past several years. All three states are rife with corruption, pork barrel spending and government inefficiencies. Hardly a day goes by that the newspapers don’t reveal yet another outrage of waste, or mismanagement or thievery.

Yet little changes in the government of these states, much to the amazement of outsiders, who often wonder why voters continue to stand for it. The answer, I tell them, is that a very small percentage of voters are paying for this waste, mismanagement and bloat. The rest pay so little that they don’t really care, or they benefit from bloated government, either through jobs in the oversized public sectors, or as users of services.

This is what you get when the few support the many--the direction the federal government is now heading. You get Connecticut, New York or (God help us) New Jersey.

In 2008, net petroleum imports will likely cost $400 billion, up nearly ten fold since Bill Clinton took office. Many oil dollars sent to Arabia, Russia and other friendly places are not spent on American goods and do not create jobs here.

Coupled with booming prices for food prices, rising gasoline, electricity and heating bills give Americans less and less to spend on nonessentials, and retail sales sink, layoffs mount, and wages falter.

U.S. exports have not kept pace to pay for oil and the other goods we buy abroad. Since Bill Clinton took office exports have increased about $1.1 trillion, while imports have jumped $1.7 trillion.

The overall result is a whopping $700 billion dollar trade gap that reduces GDP by $250 billion and longer-term economic growth by even more.

Americans use too much gasoline, and the ethanol program dents the problem much less than it pushes up prices for butter, baked goods and beef, and instigates food shortages in poor countries.

Ethanol is the sophistry begotten by pandering for farm votes. The real answer lies in more fuel efficient vehicles manufactured with readily available and reasonably obtainable technologies, within our reach.

Sadly, hardly anyone in Washington—including the trio of Senators running for President—seems willing to embrace truly rapid deployment of hybrids, lighter vehicles, fuels cells, and more efficient diesel and gasoline engines.

Our free trade policies would raise productivity and living standards if we paid for what we buy abroad with exports, because exporting industries use labor more productively and spend more R&D. However, governments in China, Japan, and much of Asia intervene in foreign exchange markets to keep their currencies artificially cheap and U.S. exports too expensive in rich markets with the greatest untapped opportunities.

McCain, Clinton and Obama all refuse to back bills pending in Congress that would get tough with Asian currency manipulation, and establish conditions for more balanced trade with those protectionist regimes.

Since the 1980s, banks have moved from making loans funded by deposits to jobbing out lending to mortgage brokers and private equity funds, and wrapping mortgage, credit card and business loan payments into complex bonds for sale to insurance companies, pension funds and other fixed income investors.

Mortgage brokers made liars loans, built on questionable assessments of home values and borrowers ability to pay. The banks understated default risks to fixed income investors, and skimmed off excessive profits and bonuses, and left too little to cover defaults.

The Bush Administration is seeking tougher standards for mortgage brokers and real estate appraisers but its financial regulation reform proposals go light on the questionable business practices of the Wall Street banks.

Predictably, fixed income investors will no longer buy bonds created by the banks, and the banks have much less money to lend homeowners, consumers and honest businesses.

The presidential contenders, all busy harvesting contributions in New York’s financial district, have not explained what they plan that would fix that mess.

On important energy, trade and banking issues, McCain offers Bush redux.

Clinton’s platform is a throwback to 1970s French statism, something President Sarkozy is trying to escape.

Obama is offering what he does best. An Elmer Gantry campaign, full of expressions of hope but thin on policy and anything truly new.

It seems elephants have long memories but few new ideas. Donkeys are endearing but even less adaptive.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

The mortgage-interest deduction harms our economy in many ways. For one, it constitutes relief for one segment of society at the expense of those who choose not to own a home. Those who don’t are forced to subsidize homeowners through theoretically higher rates of taxation on income. Considering the static approach those in Washington take to tax cuts and tax increases, the revenues “lost” due to the mortgage deduction make it more difficult for Congress to reduce marginal tax rates. So in a sense the tax relief brought about by the deduction reduces the economy’s overall vitality through greater penalties levied on actual work.

And since deductions on interest payments help to reduce the effective tax rate of many Americans, there exists less of a push to bring all manner of tax rates down altogether. Indeed, if certain segments of our society don’t feel the sting of taxation, how can we expect them to take up the cause of reducing taxes?

When the present housing moderation is considered, the mortgage deduction made buying a home more attractive such that owners themselves have become a powerful voting block. With politicians ever eager to solve problems with the money of others, fear of the special-interest group that is homeowners has engendered a variety of bailout proposals that will be funded on the backs of taxpayers whether they own or not.

Perhaps worst of all for our economic health, the mortgage-interest deduction drives capital away from the productive sector of the economy, and into the ground. 19th century economist John Stuart Mill called the latter “unproductive investment,” whereby capital is consumed rather than offered up as investment. This should concern all Americans, because to the extent that tax incentives create individual preference for consumption over savings, investment lags, and with lower investment comes lower wages.

Assuming a repeal of the mortgage-interest deduction without tax simplification, would this be so bad? Many might assume it would be in the sense that effective tax rates would rise. It’s a fair point, but that’s merely the “seen” in the concept being discussed.

Unseen once again is that with housing no longer receiving preferential treatment, individuals would be far more likely to save and invest in ways that would accrue to personal earnings. And while the direction of the dollar is the biggest driver of nominal home prices, the theoretical fall-off in demand for housing would lead to lower prices that would enable what is an unproductive asset to be purchased with a smaller percentage of total individual wealth.

Unseen also is that any presumed drop in home values would not only be made up through increased pay, but through increased wealth brought about by greater overall demand for traditional investments such as stocks and bonds. This of course flies in the face of conventional economic wisdom incorrectly suggesting that our economy is reliant on exorbitant home prices.

In answer to those who’ve bought into the charitably absurd notion that rising real-estate values are stimulative, think back to the ‘80s and ‘90s when housing greatly lagged the equity markets, and voters were much happier. It can’t be stressed enough that housing does best when the dollar is weak. In short, it’s an asset class that thrives in times of inflationary pressure; inflation correlating very well with recession. If that's not enough, consider that housing boomed under Presidents Nixon, Carter and George W. Bush. All three were or are unpopular. Think about it...

Returning to the tax implications of repeal, forgotten in the mortgage-interest discussion is the basic truth that stationary assets such as houses are easy to tax. Put simply, humans are mobile and can easily flee tax tyranny, houses aren’t and generally can’t.

Indeed, the “seen” when mortgage-interest deductions are considered is the tax advantage gained by those who’ve taken out mortgages. The “unseen,” however, is the ease with which local governments are able to capture gains achieved federally with confiscatory rates of taxation on property. Sure enough, according to a story in USA Today, property-tax collections rose 7 percent in 2006 to a record $377 billion. When local taxes are brought into the equation, effective rates of taxation rise substantially thanks to the greedy hand of local government.

The mortgage-interest deduction and all manner of housing subsidies distort investment in ways that reduce our pay, keep our rates of taxation higher than they might be, and make housing marginally less affordable for those who don’t yet own, but would like to. So while any attempt at repeal would generate all sorts of sky-is-falling protest, an end to the subsidy would pay great economic dividends that would accrue to everyone, not just the special interest that is today’s homeowner.

The second group asks the obverse of the coin: "John, how can you see a long, slow recovery? Look at all the good things like [insert your favorite bullish statistic: low interest rates, a rising stock market, the worst of the credit crisis behind us, the stimulus checks just now getting to consumers, etc.]. Don't you think that means we will get back to a full growth economy by the end of the year?"

I have given both questions some thought as to which I should answer first. I think it makes more sense to start with the bullish question first and then go into why things are not as bad as many analysts suggest.

Clowns to the Left of Me, Jokers to the Right of Me,
Here I am Stuck in the Muddle Through Middle With You!

I take some comfort in being in the middle. It is when you get on the edge that you are most often wrong, but that also means you have the most people who disagree with your position. And there are a lot of people who disagree with me. But then, a lot of people disagreed when I said the subprime crisis would be serious enough to cause a recession. As to whether I am right about Muddle Through this time, we will see. But it is where my thinking comes out.

So, let's make the case for a recession which will last at least for two if not three quarters and then a slow recovery of at least a year and half where GDP is in the range of 2% on average.

First, this recession is fundamentally a consumer recession, brought on by a bursting of the housing bubble and a credit crisis. Consumer spending is under pressure from several main areas.

First, as the housing market stalled and then began to drop, we saw a fall in housing related spending, in construction, furniture, mortgages, etc. Remember when most economists and analysts wrote last summer that there would not be a recession from the housing crisis because housing was only 5% of the economy? The rest of the economy was doing just fine, they opined. Don't worry. Be happy.

The problem is that the resulting fall in housing prices produces a negative wealth effect. I have used the following chart many times, but it is good to review it again quickly.

Notice that without mortgage equity withdrawals the US economy would have been in outright recession for two full years in 2001-2, and would have been quite sluggish for the next two years. That is what you should expect from the bursting of a major equity market bubble and 9/11. But because the value of the US housing stock was rising and doing so rapidly, people felt comfortable borrowing against the ever-rising value of their homes. We borrowed and spent our way out of that recession. Coupled with the Bush tax cuts (a very important element!) and low Fed rates, we bounced backed rather handily.

But now, home values are falling and will likely do so for another year at the least. As Woody Brock pointed out in this week's Outside the Box, we are at the beginning of a reversion to the mean on national wealth. We are getting a reverse wealth effect. People either can't or won't borrow as much and thus we get negative stimulus from housing prices. It is likely that people are going to start saving more, which while a good thing from an individual stand point, it is a drag on overall consumer spending.

Second, even though core inflation is tame, real inflation that includes the things you and I actually buy is high and rising. I drove past a gas station in La Jolla where the price of gas was over $4 a gallon. Money that is spent on gas and rising energy bills is money that cannot be spent on discretionary items. Rising food bills means that there is less money left over to buy entertainment and other modest luxury items.

Third, rising unemployment clearly means that a small but growing segment of the population has less money to spend. Unemployment is at 5.1% and is likely to rise to over 6%. That is clearly bearish of consumer spending.

All of these factors suggest a recession of at least two quarters if not three. While lower Fed funds rates and the efforts by Congress to stimulate lower mortgage rates will eventually help, it will not be an immediate panacea.

As to a slow and prolonged recovery, the "Muddle Through Recovery," the reasons to me are clear. The cause for the current recession is the bursting of the twin bubbles of the housing markets and the credit crisis. These are problems that are going to take several years to solve, not matter that the Fed does to interest rates and opening the discount window to investment banks for all sorts of mortgage and other asset backed paper. While doing so is a good thing, we still have to work our way through 3.5 million excess homes, 2 million of which are vacant. That will take a few years.

Further, we have to develop new sources for the buying of debt. We vaporized 60% of the market for debt in the implosion of CDOs, SIVs, CLOs, etc. These buyers are never going to come back. It took 15 years to create that market. It will take a few years to create its replacement. (More thoughts on how we do that in a later letter.)

Let me offer one caveat. If the Bush tax cuts are not kept largely intact you will see the recovery that I think will be coming in late 2009 and 2010 evaporate quickly. If an Obama (probably) or a Clinton (small chance) get their way, we will see the largest tax increase in history. That is not the medicine that the economy needs when it is weak already. It could easily push the economy back into recession as it will make the consumer even weaker.

A Soft Depression? Not.

So, if things are all that bad, why won't we roll into the soft Depression that Bill Bonner and others predict? It is quite easy to make a very bearish case with a falling dollar, rising inflation, a seemingly never-ending rise in oil and commodity prices, a nasty housing market crash, a frozen credit market and more.

To establish a basis for my relative optimism, I have to re-visit what is for me a painful moment in my forecasting life. This is just between you and me, gentle reader, and I would appreciate you keeping this just between us.

Back in 1998, I thought the US and the world would drift into a recession caused by the failure of some large computer programs not being fixed on time for the Y2K rollover. I did not think it would be the disaster some thought, but I did see the potential for problems.

Why? Because of one statistic that was very clear. 50% of all major software projects for 40 years did not finish on time, and a large percentage of those missed their targets by years. That number had not changed for decades.

The Y2K software problem was very real. There were thousands of huge software projects under way by late 1998 to fix the problem. I went to many software conferences and talked with the software developers and management who were quite distressed. Their concern was real.

How, I asked them (and myself), could we expect all the projects to be done on time when the clear record said that software was difficult and managers very poor at getting things done on time. While I expected most things to be fixed, it seemed reasonable to think that there would be some problem areas. And I generally got agreement from very serious managers and consultants.

I remember talking about this with the late Harry Browne, a true friend and a very wise investment writer (and the nominee of the Libertarian Party for President for two elections). Harry was generally bearish on many things. But he told me there would be no Y2K problem. I confronted him with my evidence and research.

"John, you are missing the main point. A free market figures out how to solve problems. This is a problem that we know about well in advance. It is not slipping up on us. If it must get solved in order for a company to survive, it will get solved. End of story."

I just shook my head and took comfort in my research. And I was wrong, of course. Interestingly, all the investment advice in that book ended up being right as the stock market did drop, long term interest rates fell, and the economy did go into a recession and so on. I ended up being right for the wrong reason. And some of my very first and now long term readers met me through that book, so all was not lost.

But in looking back on it, I realize what I had missed. Whenever I talked to managers at these conferences (and I talked to a lot of them), they all told me privately that they were going to meet their deadlines, but the real concern was other companies or projects. I missed the forest for the trees. Everyone was busy making sure they were going to be fine. I look back now and wonder how did I miss it?

As it turned out, Harry was absolutely right. Because there was a literal drop dead date on each of the projects, management became very focused. It seems now that we know software projects can be finished on time if the motivation is survival of your company.

It is a lesson that has been burned into me.

Now, let me throw out a very important and interesting point. Today I am in Switzerland speaking on behalf of Bank Sarasin to their mainly institutional clients. (I should note my hosts at Sarasin were most thoughtful. It is a very impressive bank with very good people.) The conference was in German except for my speech and one by a Swedish Economics professor named Dr. Kjell Nordstrom. I attended that session and am glad I did. It was a fascinating presentation.

When I travel around the world, I am used to a certain amount of America and/or Bush bashing. It is just part of the background noise.

So, I was somewhat surprised to see the professor, in the middle of a talk on why some businesses succeed and others fail, put up a rather large flag of the United States and went on to say that the US would be the dominant developed country for his life, the life of his children and the life of their children's children. You could feel the surprise in the room. It is not what they were expecting to hear. I certainly did not.

He started out saying that someone could come to the US and within 3-5 years you could become a citizen. Making a long story short, in his native Finland it took 3-4 generations before you would be considered Finnish. He went on around the world. There are very few cultures where an immigrant can become a naturalized citizen and be accepted into the culture. China? No. Japan? No.

In Germany, the professor recently talked to the top 100 managers of Siemens. This is a company that employs 462,000 people doing business in 192 countries. In that room of the top management there were 99 Germans and one Austrian. Think of similar multi-national companies in the US. Such a room would be full of diversity.

A young lady Ph.D in physics in Lajore, Pakistan does not dream at night of immigrating to China or Germany, where opportunities would be very limited. No, she and millions more like her dream of coming to the US. He said that 85% of the people living in Silicon Valley were immigrants. The best and brightest in the world choose to go there.

Because for him, America is not a country, but an idea. It is the idea that any person can come and make a life for themselves as an equal. And it is that freedom to rise or fall that makes the US what it is.

So, what does this have to do with Muddle Through? Let's return to the original question.

First, things are not as bad as they seem. Most of the US economy is doing just fine. Businesses have not overbuilt capacity, have large cash positions and lower debt than is normal at the end of a business cycle. In the 70's and 80's, we were much more dependent upon manufacturing for employment, and thus were subject to large increases in unemployment when too much capacity met slack demand and businesses cut back as quickly as they could. Even if we rise to 6 or 7 percent unemployment, that does not rise to the level of a major recession. (And yes, I know if you lose your job it seems like a depression.)

Second, the Fed has responded, if a little late, to the credit crisis, buying time for banks to find capital. While there will be many more write-offs from bad debts and mortgage paper in the future, most banks will survive in some form. The key is that the Fed did buy us time. The banks and pension funds are still going to have to write off about twice what they already have, but not all at once. It will be several years before we are through this mess, but that is why we Muddle Through and not crash. I still contend that if the Fed had allowed Bear Stearns to crash that we would experience a soft depression. It would have been ugly. But they didn't and we won't.

And while the housing crisis is really bad if you are trying to sell a home, it is also an opportunity if you are a buyer. We will work through the excess homes that are in the market, as US population is growing and the natural demand that stems from that growth will help pick up the slack.

And the credit crisis? It will get solved, because like the Y2K problem, it must be solved if we are to survive. (I am working on a paper in which I will outline how I think this will work itself out.) And the creativity that infuses this country will rise to the occasion. Yes, I know that it was that creativity coupled with greed which caused the problem in the first place. But hopefully we will get it right this time. Again, for reasons I will outline in later letters, I have reason to believe we will.

So, I think my position in the middle is the right one. We do have very real problems and will suffer a recession. The problems will not be solved quickly. But they are not fatal problems. Time is required for the markets to heal themselves. And during that time, things will be slower than has been the case in recoveries from "normal" recessions.

And let's close with a quick commercial. Investing in this environment is tricky. The speakers at my recent Strategic Investment Conference in La Jolla gave us some very good insights, and I intend to post their speeches over time. If you are an accredited investor (net worth over $1.5 million), and would like to see some of the specific recommendations and presentations of the hedge and commodity funds that presented, you can go to www.accreditedinvestor.ws, and my partners at Altegris Investments will be glad to show you the world of commodity and hedge funds. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC. Member FINRA.)

I spent part of this week in London with my partners there, Absolute Return Partners, and am quite excited about what we are doing in the area of alternative investments for those of you that are in Europe. You can also sign up at the same site mentioned above.

And now, for those who have a net worth of less than $1.5 million, as we announced a few weeks ago, I am now working with my friend Steve Blumenthal and his team at CMG to offer a variety of investment managers who can work directly with you. I am proud of the managers we have on the platform. To see the managers and their returns, and how they are doing lately in this turmoil, just click on the following link and fill out the simple form. The minimum account size is $100,000. http://cmgfunds.net/public/mauldin_questionnaire.asp

South Africa and Swiss Mountains

I am seriously struck by the beauty of Interlaken. The mountains are simply magnificent. The Eiger and the Jungfrau are awesome on their beauty. Tomorrow we will tour the area courtesy of a local guide who is a reader and return next Monday. And the Victoria Jungfrau Hotel deserves is reputation as one of the finest in the world. I highly recommend it if you are in the area.

I will leave in two weeks for South Africa. If you would like to come to the presentations I will be making there, you can go to www.investmentpostcards.com and click on the link to write Prieur du Plessis a note.

The mountains and local attractions are waiting, and I think I am going to hit the send button a little early and go be tourist for the weekend. They have had bad weather up until I arrived, and I hope that luck holds for a few more days. Have a great week.

You're glad to be stuck in the middle with you analyst.

In June 1930 the Smoot-Hawley tariff act in the US turned a stock market collapse into a crippling, decade-long Great Depression. Now, with a financial meltdown going on, is therefore NOT the time for politicians to be more protectionist. Yet last year the European Union dropped the principle of "free and undistorted competition" from its Lisbon treaty, and this year US presidential hopefuls Barack Obama and Hillary Clinton are muttering negatively about liberal trade and migration. Meanwhile, massive agricultural subsidies look likely to continue under the new US farm bill despite record high prices in international food markets – prices that are partly due to US and EU mandates and subsidies for biofuels.

The benefits of High Food Prices

According to international food agencies, today’s high agricultural prices, to which income growth in China also is a contributor, look set to continue for some years rather than being just a short-term blip. That is just the god-send that the WTO’s Doha round of multilateral trade negotiations needs to bring member governments back to the negotiating table. The agricultural talks have been the stumbling block, yet agricultural policies contribute about one-third of the global cost of subsidies and barriers to merchandise trade and so need to be an integral part of any Doha agreement.

How do today’s high international food prices help? Because they allow WTO-bound food import tariffs and other forms of farm price support to be lowered without it requiring actual prices received by farmers in the EU, US and Japan to fall much below the levels they would otherwise receive in the next few years. That may not help agricultural-exporting countries immediately, but it will in years to come when international food prices return to more-normal levels.

The Gains from Liberalization

The costs of merchandise trade barriers and farm subsidies are very conservatively estimated to be of the order of $300 billion a year. It assumes competition is perfect, which it is not, and that nothing happens to services policies under Doha, which again is too pessimistic. We suggest that if more realistic assumptions are used, estimates of the global cost of protection actually rise from anywhere between $460 billion a year to over $2.5 trillion.1

But more trade in goods is only part of economic liberalisation. Another is trade in "factors of production", including labour. Several recent studies have suggested huge gains even from modest liberalisations in the mobility of labour. For example, an increase in migrants from developing to high-income countries that accumulates to a 3 percent boost in the latter’s labour force (both skilled and unskilled) by 2025 might increase global income by nearly $700 billion a year by 2025. This flow represents a total of 14 million workers and their families coming at the rate of a little over 500,000 extra migrant workers per year. It entails a loss of merely 0.4 percent of the developing countries’ workforce, and even in the developing countries’ skilled category it represents only a 1.7 percent loss of workers. Even if you subtract the cost of moving to the host country for immigrants and the social-welfare benefits they may get when they arrive, the net benefits are sizeable compared with those from freeing up trade in goods.

Estimates of the net benefits from a permanent partial reform of goods trade barriers and farm subsidies following the Doha round, and those from expanded migration over the period to 2025, have been generated using the same economy wide global economic model that is used by the World Bank for projecting world economic growth. The figures vary with assumptions and the discount rate used, but projections through to 2100 show that developing countries would enjoy an increasing share of the benefits of free trade as their economies expand. Under an optimistic trade reform scenario, the present (2008) value of net benefits of trade liberalisation (if we ignore the impact reform could have on economic growth rates) is almost the same as that from 25 years of expanded migration from a global perspective.

Specifically, the net gains from Doha partial trade reform through to 2100 – even if no growth dividend is included – are as much as $11 trillion using a 6% discount rate, or $36 trillion if 3% is used, while those from greater migration to 2025 are $12 trillion or $38 trillion at 6% and 3% discount rates, respectively. Importantly, it is citizens of today’s developing countries who overwhelmingly would reap the lion’s share (around three-quarters in aggregate) of those benefits. If one adds in the potentially large, but less well estimated, effects of liberalisation on economic growth in the decade and a half following the reforms, the benefits are very much larger.

Conclusion

In sum, this evidence strongly supports the view that gradual reductions in wasteful subsidies and trade barriers, including barriers to migration, would yield huge benefits for little economic cost. At the same time, global inequality and poverty would be reduced. Although there might be some local social and environmental problems, these are usually tackled better and more cheaply by instruments other than trade barriers or subsidies. The most obvious way to achieve the benefits of liberalisation is via a successful conclusion to the Doha round of trade negotiations. If this does not happen soon, pressure for increased migration is to be expected, and a positive response to it could be hugely beneficial for the world’s poor. Such a response by rich countries to increase their intakes of migrant workers is not something that requires multilateral agreement, and so should be easier. Yet politicians are trying to keep migrants out, not let them in.

Kym Anderson is the George Gollin Professor of Economics and Foundation Executive Director of the Centre for International Economic Studies (CIES) at the University of Adelaide and CEPR Research Fellow.

L. Alan Winters is a Professor of Economics at the University of Sussex and CEPR Research Fellow.

References

Anderson, K. and L.A. Winters (2008), “The Challenge of Reducing International Trade and Migration Barriers”, published by the Copenhagen Consensus 2008 project and also as CEPR Discussion Paper 6760, March.

World Bank (2006), Global Economic Prospects 2006: Economic Implications of Remittances and Migration, Washington DC: The World Bank.

Footnotes

1 This column draws from the authors’ paper for the Copenhagen Consensus 2008 (CC08) Project. The views expressed are the authors’ alone.

That stability reflected a simple quid pro quo: regulation in exchange for freedom to operate. Governments brought commercial banks under prudential regulation in exchange for public provision of deposit insurance and lender-of-last-resort functions. Equity markets were subjected to disclosure and transparency requirements.

But financial deregulation in the 1980s ushered us into uncharted territory. Deregulation promised to spawn financial innovations that would enhance access to credit, enable greater portfolio diversification, and allocate risk to those most able to bear it. Supervision and regulation would stand in the way, liberalizers argued, and governments could not possibly keep up with the changes.

What a difference today's crisis has made. We now realize even the most sophisticated market players were clueless about the new financial instruments that emerged, and no one now doubts that the financial industry needs an overhaul.

But what, exactly, needs to be done? Economists who focus on such issues tend to fall into three groups.

First are the libertarians, for whom anything that comes between two consenting adults is akin to a crime. If you are selling a piece of paper that I want to buy, it is my responsibility to know what I am buying and be aware of any possible adverse consequences. If my purchase harms me, I have nobody to blame but myself. I cannot plead for a government bailout.

Non-libertarians recognize the fatal flaw in this argument: Financial blow-ups entail what economists call a "systemic risk" - everyone pays a price. As the rescue of Bear Stearns shows, the government may need to bail out private institutions to prevent a panic that would lead to worse consequences elsewhere. Thus, many financial institutions, especially the largest, operate with an implicit government guarantee. This justifies government regulation of lending and investment practices.

For this reason, economists in both the second and third groups - call them finance enthusiasts and finance skeptics - are more interventionist. But the extent of intervention they condone differs, reflecting their different views concerning how dysfunctional the prevailing approach to supervision and prudential regulation is.

Finance enthusiasts tend to view every crisis as a learning opportunity. While prudential regulation and supervision can never be perfect, extending such oversight to hedge funds and other unregulated institutions can still moderate the downsides. If things get too complicated for regulators, the job can always be turned over to the private sector, by relying on rating agencies and financial firms' own risk models. The gains from financial innovation are too large for more heavy-handed intervention.

Finance skeptics disagree. They are less convinced that recent financial innovation has created large gains (except for the finance industry itself), and they doubt that prudential regulation can ever be sufficiently effective. True prudence requires that regulators avail themselves of a broader set of policy instruments, including quantitative ceilings, transaction taxes, restrictions on securitization, prohibitions, or other direct inhibitions on financial transactions - all of which are anathema to most financial market participants.

To grasp the rationale for a more broad-based approach to financial regulation, consider three other regulated industries: drugs, tobacco, and firearms. In each, we attempt to balance personal benefits and individuals' freedom to do as they please against the risks generated for society and themselves.

One strategy is to target the behavior that causes the problems and to rely on self-policing. In essence, this is the approach advocated by finance enthusiasts: Set the behavioral parameters and let financial intermediaries operate freely otherwise.

But our regulations go considerably further in all three areas. We restrict access to most drugs, impose heavy taxes and marketing constraints on tobacco, and control gun circulation and ownership. There is a simple prudential principle at work here: Because our ability to monitor and regulate behavior is necessarily imperfect, we need to rely on a broader set of interventions.

In effect, finance enthusiasts are like America's gun advocates who argue that "guns don't kill people; people kill people." The implication is clear: Punish only people who use guns to commit crimes, but do not penalize others by restricting their access to guns. But, because we cannot be certain that the threat of punishment deters all crime, or that all criminals are caught, our ability to induce gun owners to behave responsibly is limited.

As a result, most advanced societies impose direct controls on gun ownership. Likewise, finance skeptics believe that our ability to prevent excessive risk-taking in financial markets is equally limited.

Whether one agrees with the enthusiasts or the skeptics depends on one's views about the net benefits of financial innovation. Returning to the example of drugs, the question is whether one believes that financial innovation is like aspirin, which generates huge benefits at low risk, or methamphetamine, which stimulates euphoria, followed by a dangerous crash.

Dani Rodrik, a professor of political economy at Harvard University's John F. Kennedy School of Government, is the first recipient of the Social Science Research Council's Albert O. Hirschman Prize. His latest book is "One Economics, Many Recipes: Globalization, Institutions, and Economic Growth."