RealClearMarkets - Articles

Whether readers possess a little or a lot of knowledge concerning the Fed, what will strike them most about Auerbach’s account were the boldly dishonest measures taken by the Fed, and in particular Alan Greenspan, to hide the discussions that centered around interest-rate decisions. When we consider that the Fed serves at our pleasure, and issues the currency that is the lubricant of our economic activity, it’s shocking to learn how eager Greenspan et al were to keep their doings secret.

The above serves as the book’s most entertaining thread whereby Gonzalez sought greater transparency from the Fed about the thinking that went into rate decisions. Remarkably, Auerbach reveals that for seventeen years our central bank stuck by the falsehood suggesting that it kept no records or minutes pertaining to the FOMC meetings where rates were discussed. When asked by Rep. Maurice Hinchey if meeting records existed at all, Greenspan replied: “There is no permanent electronic record, this is correct. We obviously have rough notes.” When he finally achieved access to the allegedly “rough notes,” Auerbach hints with a bit of sarcasm that the “neatly typed FOMC transcripts I later viewed were not rough notes.”

Furthermore, as was the case with every FOMC meeting, according to Auerbach participants would “speak into microphones with voice-activated green lights that indicate the recording of their utterances.” Considering the protests of many FOMC members suggesting they were unaware that they were being recorded, Auerbach notes that at best this “was not a good sign, given the skill level desired in FOMC members.”

And if we ignore the obvious problems that would result from a secret, unaccountable bureaucracy, Greenspan’s own inscrutability itself proved to be very problematic. As Auerbach entertainingly shows, the newspaper headlines pertaining to Greenspan’s Q&A at a Seattle banking conference in 2000 spoke to an annoying unwillingness on his part to be clear. Indeed, drawing on the same answers, the New York Times concluded that Greenspan felt a recession was on the way, the Washington Post assumed he felt a recession unlikely, the Baltimore Sun guessed that he believed recession risks were rising, and the Wall Street Journal’s headline was sanguine; as in “Fed Chairman Doesn’t See Recession on the Horizon.” Sadly, in his mostly unremarkable autobiography, The Age of Turbulence, Greenspan never explained his desire to seemingly keep everyone in the dark.

When we consider the great technological strides made by commercial interests over the years, Auerbach’s description of the Fed’s fleet of 53 airplanes proves very interesting. Despite a 1999 survey showing that banking systems around the world were increasingly shunning paper checks for electronic money transfers, the U.S. still “boasted” a system whereby 68.6 percent of payments were made in paper fashion. Though it sought to make its airplane operations similarly opaque, Auerbach shows the folly of the Fed planes moving 43,000 pounds of checks per day, not to mention that those operations lost money. The Fed could of course subsidize its own version of the Pony Express thanks to its ability with the click of a mouse to issue money in exchange for interest-bearing bonds offered up by banks.

On the subject of economists, Auerbach notes that the Fed is “one of the largest employers of U.S. economists.” In addition to the hundreds on its staff, the Fed also contracts with many in academia. On its face this shouldn’t be surprising given the nature of the Federal Reserve’s operations, but then Auerbach points us to a comment from the late Nobel Laureate Milton Friedman who made the interesting observation that the Fed’s enhanced public standing is aided by its ability to buy “up its most likely critics.” If top economists work for the Fed in some form or fashion, it’s less likely that they’ll criticize its doings. When the press is factored in, Auerbach pointed to the Fed’s tendency to freeze out journalists unwilling to use leaked information in a friendly way.

Amidst Auerbach’s intriguing critiques of the Fed, there were other points made that were more disagreeable. Auerbach’s mention of the impact of tax cuts, particularly his view that they shifted the burden to those not wealthy was a non sequitur for a book about the Fed, not to mention that the top 1% of taxpayers presently account for 35 percent of federal revenues. While it says here that the S&L crisis was the direct result of federal efforts to privatize profits while socializing losses, Auerbach perhaps contradicts himself in suggesting that Charles Keating’s Lincoln Financial was corrupt sentences before noting that the charges against the same person were eventually dismissed.

Auerbach argues that Greenspan’s garbled statements helped him “retain his position as Fed Chairman through four administrations,” but that too seems somewhat contradictory. Greenspan was able to be opaque precisely because he was mostly successful as Fed Chair. Had stocks nosedived throughout his tenure, his and Gonzalez’s efforts would have met with much more success, not to mention that Greenspan wouldn’t have lasted four terms.

The above brings us to the biggest area of disagreement in what is an important book. Auerbach acknowledges that with the majority of all dollars issued presently overseas, past views suggesting a relationship between the money supply and U.S. inflation are less telling. Of course. The Fed has monopoly control over dollar issuance, but it cannot control where those dollars go. Friedman, the modern father of monetarism, acknowledged as much in 2003.

The problem there is that Auerbach ties the strong stock market of the late ‘90s to excessive money growth. Even if we ignore where the majority of dollars issued went ten years ago, the basic truth is that as evidenced by the strength of the dollar versus gold and foreign currencies during the time in question, the Fed’s major mistake of the late ‘90s was in failing to accommodate a rising economy with more money. In short, technology stocks didn’t boom due to too much money, but instead rose because with the dollar dear commodities were collapsing; thus driving more investment than normal into the technology sector.

In addition to advocating a reworking of the banking regulatory structure, along with lobbying restrictions on the Fed, Auerbach’s major conclusion is that all FOMC meetings “should be recorded, and the unedited transcripts should, ideally, be available within one month to the chairmen and ranking members of the Senate and House Banking Committees.” I say that’s not going far enough.

In the end this is our money we’re talking about, so rather than hope that those in Congress will be more transparent, we should acknowledge that the Fed’s power lies in its ability to secretly manipulate the dollar and interest rates. In that sense, the better suggestion would be for the Fed to float the cash rate it targets, all the while returning us to the gold standard that made McChesney Martin’s admitted inexperience less relevant. Under a gold-exchange standard, there would be zero mystery about the Fed’s operations in that the citizenry would be well aware that the Fed’s actions would be limited to extinguishing/creating money in order to achieve a stable dollar price. Markets would prevail when it comes to the all-important value of the dollar. In short, with a gold standard the Fed would be on auto-pilot, and we’d all be better off.

Perhaps softened by his romance, Sarkozy has shifted gears and earlier this year seemed to discard his economic reforms in favor of a new “politics of civilization” with more emphasis on quality of life and ecological issues. Sarkozy even commissioned two Nobel Prize-winning economists to fashion a new parameter of national growth—a sort of Gross Domestic Contentment index that stresses advances in quality of life over purely economic gains registered by a traditional Gross Domestic Product. Announcement of the new index prompted the leader of the Socialist opposition party to sneer that, “When you cannot achieve growth you change the indicators.”

Sarkozy’s problem seems to be that although he clearly understands how the government’s high taxes and stultifying labor market regulations have inhibited the French economy, he also thinks that many of the distinctive characteristics of French economic life--from protections against getting fired to early pensions and a short work week--make French workers who are already employed so happy that he can’t afford to wipe away those employment perks.

But maybe Sarkozy should take a closer look at what makes workers content. He might be startled at what he finds. For one thing, the French, for all of their job security and employment perks (as well as great food and excellent wine), are among the least happy people in the developed world, according to an intriguing and well-researched new book by Syracuse University economist Arthur Brooks, Gross National Happiness. According to the International Social Survey cited by Brooks, only 35 percent of the French say they are completely or very happy, compared to 56 percent of Americans. Among “old Europe,” only citizens of the former West Germany are less happy than the French—maybe because they’re still burdened by the steep tab of integrating the old, economically destitute East Germany. Even so, the French are not far from the European norm, which is well below that of the United States in terms of overall life satisfaction.

Work has a lot to do with this, says Brooks, who headlines one of his chapters, "Happiness is a Full-Time Job." He notes that in surveys more than half of all Americans say they are completely or very satisfied with their jobs, compared to only 35 percent of the English, 33 percent of the Spanish and 32 percent of the French. There’s no mystery why, Brooks contends. Even as our media commentators warn of rising worker anxiety in a rapidly changing American economy, the strictures that many European countries have put in place to protect workers make them less willing to risk changing jobs, and companies less willing to expand their workforces, trapping many employees in their jobs whether they like them or not. “If finding a new job is a difficult or impossible task, I will hold on to my old job for dear life, even if it is a bad match for my interests, skills and tastes,” writes Brooks.

Much of the commentary on work, both here and in Europe, has consistently gotten all of this wrong. Without bothering to consult the data, commentators have assumed that workers are much better off—and hence happier—in Europe. After all, they not only have more job security there, but work shorter hours, take on average twice as much vacation time as we do, and retire about five years earlier. As Time magazine once observed, here in America “religion comes packaged with a stern message that hard work is good for the soul. Modern Europe has avoided so melancholy a lesson.” Or as the Telegraph in London once suggested, we work so hard because Americans are “terrified of losing their jobs.”

Actually, what the data show are that people around the developed world find fulfillment in work and often work hard because they enjoy it. That’s true, moreover, not only of those in high-powered white collar jobs, but across the income spectrum. When, however, workers stay in jobs they dislike because their labor market is not very flexible and opportunities are not great, they look for pleasure outside of work and demand more time off and shorter workweeks. Those are substitutes, though poor ones, for the fulfillment one can find in work. That’s one reason why the European country closest to ourselves on international surveys of satisfaction are the Swiss, who enjoy high levels of investment and trade freedom and a more flexible labor market than most Europeans.

Sarkozy may be figuring at least some of this out. After his “politics of civilization” met with a cool reception, he now seems to be trying to get his old agenda back on track. Last week he abruptly proposed ending France’s 35-hour work week, which was instituted in 1998 under the assumption that if workers toiled fewer hours, there would be more work for the unemployed, and that would spur economic growth. Of course, only in France do they believe that having employees work less would boost growth, and of course it hasn’t worked out that way at all.

Still, French unions are up in arms and ready to strike over the proposal. But that may be because Sarkozy is going about his reform in the wrong way. Based on what Brooks has found, the French President should be telling workers he’s lifting the restrictions on working more than 35 hours a week so that they can enjoy themselves more. A few, at least, will actually understand what he’s talking about, and France will be the better for it.

In effect, the Fed chief is putting a floor under the dollar. But there’s more here. He added that “we are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations, and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations.”

The Fed head has finally figured out that the weak dollar is driving up inflation. He’s also reaffirming the Fed’s traditional priority of generating price stability. In the process, he may be restoring an inflation-targeting policy that has been badly undermined of late. Hopefully this means the central bank will go back to using forward-looking market-price indicators, such as the dollar and gold, in its policy decisions.

Bernanke’s comments follow on similar statements made by Fed governor Kevin Warsh, Dallas Fed president Dick Fisher, and Minneapolis Fed president Gary Stern. And they mark the first time in his tenure that he has explicitly discussed the dollar-inflation connection.

Now, Treasury-man Hank Paulson in recent days has been talking about the dollar. But he still frames the discussion in terms of a strong dollar being in the national interest. Unfortunately, that phraseology remains a euphemistic reference to the Bush administration’s long-held policy of dollar neglect. Not until Mr. Paulson uses the new Bernanke language — “that the dollar remains a strong and stable currency” — will we know the White House is shifting gears to King Dollar. Even better, Mr. Paulson could use the term “dollar appreciation.”

But without question, Bernanke would not have changed his language unless he got a signoff from Paulson. So these new statements are the most hopeful sign yet that U.S. financial bigwigs are starting to get their arms around the greenback.

In currency trading following Bernanke’s speech, the dollar rose significantly and gold fell. In the money markets, futures traders are pricing in a Fed rate hike, perhaps as early as late October, with a whole series of rate hikes predicted for next year. I don’t expect the Fed to rush into rate hikes anytime soon. However, there is another way for the central bank to bolster the buck.

In recent months, the Fed’s emergency-lending operations have injected something like $400 billion of cash reserves into the troubled banking system. So in the months ahead, while keeping the fed funds target rate steady at 2 percent, the Fed can gradually unwind some of these emergency loans as the banking system continues to heal and balance sheets continue to repair.

This would reduce some of the excess cash that has contributed to the weaker dollar. Meanwhile, a more reliable currency could end the speculative oil-and-commodity boom that has been leaking into consumer prices via the beleaguered greenback. Then, as the economy picks up later this year, the Fed can move to a gradual nudging-up of its target rate.

All this said, the Bernanke move is a huge plus for prosperity. And for the life of me I don’t know why Sen. John McCain doesn’t take a cue from Bernanke and mount a King Dollar campaign of his own.

Sen. McCain needs to speak to the food-and-oil-price-hike inflationary fears of Main Street voters across the country. Why not promote a “McCain Dollar,” taking a page from Reagan and his anti-inflation run in 1980? Not only to send a message to cash-strapped families, whose incomes are being swallowed by weak-dollar food-and-gas prices. But also to send a strong-dollar message around the world to bolster American power and prestige.

There are a lot of things broken in Washington right now, including the dollar. There’s overspending and earmarking. There’s a ridiculously complex tax system that imposes multiple tax burdens on capital, investment, and saving. There’s the entitlement problem. And the energy system needs to be totally deregulated so that free-market forces can promote a full portfolio of conventional and new energy sources.

Big Mac can fix what is broken in Washington, including the busted dollar. The sooner Mr. McCain adopts this reform message, the closer he’s gonna get to victory in November.

Quite simply, a strong currency, along with pro-growth tax, spending, entitlement, and energy reform, is the winning message.

The problem there is that savings gluts are very much a misnomer. Owing to the basic truth that we live in a world of infinite wants with entrepreneurs ever eager to fill those needs, it seems more than a reach that entrepreneurs and businesses ran out of ideas in this decade.

More realistically, just as all roads used to lead to Rome, so does much of modern economic history lead to the dollar. When the latter began to weaken in 2001, commodities began their long rise upward. While it’s not a perfect inflation hedge, housing has historically risen with commodities, and with the greenback once again weak, capital rushed to the real; housing one of many “real” beneficiaries.

Bernanke suggested that the “housing boom came to an end because rising prices made housing unaffordable,” but it’s more truthful to say that inflation is always and everywhere an economic retardant. The falling dollar led to an investment slowdown that was going to inevitably impact both mortgage holders and those hoping to achieve home ownership with a mortgage.

That is so because in a world of limited capital, inflationary periods re-direct capital away from businesses and job-creating innovators. This explains why inflation correlates so well with recession and broad economic uncertainty, and in view of the falling dollar in recent years, helps to explain the malaise in the electorate. Inflation cuts in myriad ways, but most notably it reduces the value of our pay while at the same time reducing the amount of investment necessary to boost our income in order to keep up with inflation.

And when commodities are considered, Bernanke made plain that at least in his public model, the commodity boom is not related to the dollar. So while it would be folly to suggest that simple demand hasn’t played some role in the rise of commodities such as oil over the years, the fact remains that oil is up 344 percent in dollars since 2001 versus 130 percent in euros.

Rather than acknowledge the obvious; as in the miscreant role of the U.S. Treasury and Fed in the commodity spike, Bernanke persisted in his view that the commodity boom is a growth concept, suggesting that “commodity prices will level out, a forecast consistent with our expectation of some overall slowing in the global economy and thus in demand for raw materials.” Some reporter or politician in a utopian world might ask Bernanke in light of his analysis why the world economy and stocks boomed in the ‘80s and ‘90s alongside the collapsing price of oil and all other commodities.

And if there remains any uncertainty about what Bernanke believes, he added that, “the prices of a number of commodities, most notably oil, have continued upward recently” even though the foreign exchange value of the dollar has “remained generally stable in the past few months.” What Bernanke ignores is that the interplay between paper currencies reveals very little, particularly if they’re all weakening at the same time. Indeed, it’s perhaps due to Bernanke’s wanting commodity analysis that commodities only fell a slight amount in response to his dollar comments.

Regarding his dollar remarks, after suggesting that future rate cutting is on hold for now, Bernanke said the “challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation.” He might have added that the economic challenges he referenced were conceived through past dollar weakness.

But when we consider that the U.S. Treasury remains the chief mouthpiece for the dollar, Bernanke’s comments were notable, and commodities as mentioned trickled down slightly as a result. Whatever the longer-term outcome, investors should welcome any statements from monetary authorities suggesting there’s at least some concern about the impressively debased greenback.

Still, the various U.S. equity indices fell in response to the speech. Conventional wisdom would suggest that this has to do with Bernanke’s allusion to a rate-cutting pause, but that analysis seems wanting.

Explicit in the above reasoning is the broadly held view among commentators that Wall Street desires cheap money. As evidenced by the historically negative correlation between inflation and stock returns, nothing could be further from the truth.

More realistically, the great voting booth that is the stock market is not pleased with the way in which Bernanke might seek to achieve a strong dollar. Lest we forget, the dollar weakness that we’re presently experiencing did not just begin last August. Instead, the dollar weakened on and after 9/11, fell further amidst tariff impositions and Sarbanes-Oxley, and actually fell the most against gold and oil when the Fed engineered 425 basis points of rate increases from 2004-2006. While history says rate increases are a dollar negative, at the very least it should be said that the greenback’s problems began long ago.

Going forward, what will cheer investors is not talk of rate increases that have very little to do with liquidity, and that will serve to invert the yield curve. Instead, it should be remembered that money defined in gold terms is low interest-rate money, and when money has the stability offered by the gold definition, oil is stable and cheap.

In short, what investors really want is for the Treasury to announce in concert with the Fed a stronger and more credible market-based dollar definition. If this comes to pass, markets will rally for our monetary authorities removing a weak and unstable variable – the dollar - from ours and world economy. It can’t be said enough that the dollar is the most important price in the world.

Can a senator, with so many things on his mind, know so precisely how the price of gasoline would respond to that increase in the oil supply? Schumer does know that if you increase the supply of something, the price of it probably will fall. That is why he and 96 other senators recently voted to increase the supply of oil on the market by stopping the flow of oil into the Strategic Petroleum Reserve, which protects against major physical interruptions. Seventy-one of the 97 senators who voted to stop filling the reserve also oppose drilling in the Arctic National Wildlife Refuge.

One million barrels is what might today be flowing from ANWR if in 1995 President Bill Clinton had not vetoed legislation to permit drilling there. One million barrels produce 27 million gallons of gasoline and diesel fuel. Seventy-two of today's senators -- including Schumer, of course, and 38 other Democrats, including Barack Obama, and 33 Republicans, including John McCain -- have voted to keep ANWR's estimated 10.4 billion barrels of oil off the market.

So Schumer, according to Schumer, is complicit in taking $10 away from every American who buys 20 gallons of gasoline. "Democracy," said H.L. Mencken, "is the theory that the common people know what they want and deserve to get it good and hard." The common people of New York want Schumer to be their senator, so they should pipe down about gasoline prices, which are a predictable consequence of their political choice.

Also disqualified from complaining are all voters who sent to Washington senators and representatives who have voted to keep ANWR's oil in the ground and who voted to put 85 percent of America's offshore territory off-limits to drilling. The U.S. Minerals Management Service says that restricted area contains perhaps 86 billion barrels of oil and 420 trillion cubic feet of natural gas -- 10 times as much oil and 20 times as much natural gas as Americans use in a year.

Drilling is underway 60 miles off Florida. The drilling is being done by China, in cooperation with Cuba, which is drilling closer to South Florida than U.S. companies are.

ANWR is larger than the combined areas of five states (Massachusetts, Connecticut, Rhode Island, New Jersey, Delaware), and drilling along its coastal plain would be confined to a space one-sixth the size of Washington's Dulles airport. Offshore? Hurricanes Katrina and Rita destroyed or damaged hundreds of drilling rigs without causing a large spill. There has not been a significant spill from an offshore U.S. well since 1969. Of the more than 7 billion barrels of oil pumped offshore in the past 25 years, 0.001 percent -- that is one-thousandth of 1 percent -- has been spilled. Louisiana has more than 3,200 rigs offshore -- and a thriving commercial fishing industry.

In his book "Gusher of Lies: The Dangerous Delusions of 'Energy Independence,' " Robert Bryce says Brazil's energy success has little to do with its much-discussed ethanol production and much to do with its increased oil production, the vast majority of which comes from off Brazil's shore. Investor's Business Daily reports that Brazil, "which recently made a major oil discovery almost in sight of Rio's beaches," has leased most of the world's deep-sea drilling rigs.

In September 2006, two U.S. companies announced that their Jack No. 2 well, in the Gulf 270 miles southwest of New Orleans, had tapped a field with perhaps 15 billion barrels of oil, which would increase America's proven reserves by 50 percent. Just probing four miles below the Gulf's floor costs $100 million. Congress's response to such expenditures is to propose increasing the oil companies' tax burdens.

America says to foreign producers: We prefer not to pump our oil, so please pump more of yours, thereby lowering its value, for our benefit. Let it not be said that America has no energy policy.

georgewill@washpost.com

Another reason for this phenomenon, it seems to me, is that most gold standard advocates today don't really have a sufficient understanding of monetary economics, in the sense that a mechanical engineer understands the machining of metal. Instead, they have a series of platitudes and vague principles, punctuated by periodic references to the Holy Mises. Platitudes and principles are fine, but they don't serve in the fundamental engineering-like process that creates a working monetary system. They are aware of their insufficiencies, in the same way that mainstream central banker types are also aware of their insufficiencies, which makes them cling to the existing interest-rate manipulation system rather than proposing sensible alternatives. The mainstream central banker types are equally impotent at creating a working monetary system, because they also lack the fundamental nuts-and-bolts understanding that would allow them to create functioning systems with any sort of features they desire.

The gold standard advocates have thus migrated somewhat toward the "let's all use gold coins" system, because it seems like there is nothing to manage. You just make coins out of gold --which, you have to admit, is a pretty simple rule, and doesn't require a paper-currency manager as would be required with a gold-linked paper money system.

The other favorite is the "let the free market figure it out" system, which means "I have no idea but maybe someone else does." In the 19th century, there was no government monopoly on currency production, and indeed many hundreds of private commercial banks distributed their own paper currencies, which were linked to gold. You can still see this system a little bit in Hong Kong today. However, all of these hundreds of private commercial banks had to have someone, on their staff, who understood the nuts-and-bolts of how to link a paper currency to gold, if they were going to be successful. So, the "let the free market figure it out" solution doesn't escape the need for a monetary engineer to make the system work.

As I've argued, the bullion coin system is not a particularly bad system, when used in a small area. Ecuador could probably adopt a bullion-coin system with no particular ill effects. However, it is not a system that is suitable for the world as a whole. Let's try to understand why, which is also the reason why paper monies were widely adopted during the industrial 19th century.

The fact of the matter is, there really isn't that much gold out there. Gold is hardly ever used up or thrown away, and as a result, about 85% of all the gold ever mined in all of history still exists in human possession. Over these many thousands of years of gold mining, humans have been able to extract about four billion ounces of gold. Historically, this amount has risen by about 2% per year due to mining, but recently, world gold production has been falling off rather dramatically despite recent economic incentives to produce more. It looks like we may have hit "Peak Gold," running into the physical limitations of availability in economic concentrations the Earth's crust.

So, four billion ounces is about all we're going to be able to work with. There are almost seven billion people in the world. So, if they all use gold coins, how many gold coins are they going to own?

A traditional problem with gold coins is that they are simply too valuable. A 1/10th oz. coin is about the smallest coin that is practical. There was a 1/20th oz. gold coin in the U.S., but it was really teeny and thus rather impractical and unpopular. A 1/10th oz. gold coin today would be worth about $100. When is the last time you saw a $100 bill? Although they are used commonly outside the U.S., particularly in illegal cash transactions, within the U.S. the $100 bill is very rare. The reason it is rare is not that the government refuses to make them -- the government is willing to trade a $100 bill for five $20 bills at any time -- but that people don't like to use them.

Traditionally, smaller transactions were carried out with silver and copper coins. This introduces new problems. The smallest practical silver coin is perhaps 0.05 (one twentieth) oz. The old silver dime of the 1950s had about 0.07 oz. of silver, and was 90% silver by weight. Using the traditional 15:1 silver:gold value ratio, at $1000/oz. gold, the value of the 1950s silver dime would be about $4.60 today. So, even the smallest silver coin is of rather high value, which necessitates the introduction of copper coins. Now, we've got a three-metal system, if you're going to make the coins have a bullion value equivalent to their face value. The actual market values of the metals drift over time, which introduces all kinds of new problems.

The point is, a "gold coin system" is really a silver-and-copper coin system. Today, there is about 1 billion oz. of silver in the world that could conceivably be made into coins. Remember, most small-scale transactions would be done with silver coins. You wouldn't see gold coins very often, but silver coins would be used every day, at the grocery store for example. How are seven billion people going to make a monetary system with one billion ounces of silver coins? Today, if we use the 15:1 silver ratio, that billion ounces of silver would be worth about $60 billion. There are about $800 billion of U.S. notes and coins in the world, not to mention the notes and coins of other governments. We can see that there isn't a whiff of a chance of making a silver coin system that would serve the world -- although maybe Ecuador could get away with it.

"Yes, but....," you say, "you could make the coins into token coins, and make them redeemable for gold on demand." This was the case for the silver coins in the U.S. after 1875 or so. Their contained silver value was less than the face value of the coin. The $1 silver coin had about $0.50 of silver in it. However, you could trade twenty $1 silver coins for a $20 gold coin with the government, which is why the coins maintained their value above their commodity value. You could even make a $1 silver coin with $0.001 of silver in it, really just silver plating over aluminum or something like that. This would work just fine as well. It's how coins work today. However, we can see that a $1 silver coin with $0.50 or $0.001 of silver in it is a token coin, which is functionally equivalent to paper money. A paper $1 bill is like a silver coin with no silver in it at all. So, once again, we have the need for a token coin/paper money manager, who manages the supply of coins/bills to maintain their value at the proper parity.

The bullion-coin advocates like to imagine that bullion coins cannot be devalued. Baloney. Governments were devaluing coins two thousand years before paper money was invented. Just take the $20 gold coin, containing an ounce of gold, and stamp it as a $1000 gold coin, containing an ounce of gold. This is what the Roman goverments did to their silver coins in the fourth century. It's what the colony of Massachusetts did in the 18th century. It is as common as water. "Yes, but...," you can hear the gold coin advocates argue already,"at least the coins you own already wouldn't be devalued." That's true. But, the government could just declare holding such pre-devaluation coins to be illegal. The U.S. government did this in 1933, which was the first permanent devaluation in the dollar in U.S. history. Gold coins stayed illegal until 1974.

Actually, you could have a $20 gold coin and a $1000 gold coin, both containing an ounce of gold, trade side-by-side. The $20 coin would have a commodity value of $20, and the $1000 coin would be a token coin with a commodity value of $20. "But, wouldn't everyone take the $20 coin instead, since they both have the same commodity value?" Well, the five-cent coin in the U.S. now has a commodity value of $0.07 or so. The $20 bill has no commodity value at all. But, they still trade side by side at their face values.

* * *

How much money do you own today? I mean real money -- base money -- notes, coins, and bank reserves. Probably no bank reserves unless you are both very, very wealthy and also very, very financially creative. So, notes and coins. Look in your wallet. I bet it is less than $500.

Most of what people think of as "money" is really a loan to someone else, like their banker. What happens when you buy something with a debit card, check or credit card? In this case, your banker pays the recipient (actually the recipient's bank) in real money, in this case a transfer of bank reserves through the bank clearinghouse at the Fed. All monetary transactions take place with base money, which is to say, real money. We must deal with the real world here, not some fantasy world in which people buy houses, or stocks and bonds, with a leather sack of doubloons. We've already talked about replacing token notes and coins with bullion. A bullion-based system could replace these bank reserves, which are now electronic, with bullion bars stored in the Fed's basement. The Fed already does this for central banks around the world. Instead, there would be a cage in the basement with Citibank's bank reserves in the form of gold, and the bars would shuffle around each day as banks made their payments. You could even make a pooled system, whereby the banks would have an unallocated claim on bullion stored at the Fed, and then you wouldn't even have to move the bars around.

The amount of bank reserves is really not very much -- about $80 billion in the U.S. -- and this could conceivably be replaced by bullion. You have to admit, it is a very efficient system, considering the volume of transactions in dollar terms and the very small amount of acutal money (bank reserves) used to make the transactions. Theoretically, if everyone made their transactions in this fashion, using debit cards and such, rather than in bullion coins, then a relatively small amount of bullion could serve. However, this also means that nobody really owns any bullion coins, and that all the bullion is owned by the large banks. In effect, we've substituted a paper dollar, linked to gold, with an electronic bank account linked to gold, which is not really any different. In reality, both would be necessary anyway.

What if all transactions were done with "electronic money" (actually bank accounts)? Then nobody would own any bullion coins, although the banks would make payments in bullion to each other. Thus, ironically, you could have an all-bullion system, which is really a no-bullion system. "M2" consists of notes and coins, demand deposits, savings accounts and money market funds, and small time deposits. In May 2008, U.S. M2 was $7.676 trillion. Theoretically, you could go to the bank and ask for your loan to the bank to be repaid in bullion coin. However, if everyone tried to do this, or even a small number of people tried this, the bank would shut its doors and say "sorry, no can do," for the simple reason that such a quantity of bullion does not exist on this planet.

* * *

I think we can see why an all-bullion system is impractical to the point of impossibility on any kind of large scale. Thus, we would need to have a currency manager, who knows how to manage supply to maintain a currency's value at its bullion parity. This is not really very hard to do, but you aren't going to escape that need by making silly claims about bullion coins or the "free market." The Holy Mises is not going to fly down from heaven and smite your enemies for suggesting that it's time to move beyond empty platitudes to real solutions.

I am actually a fan of Mises. He was without a doubt one of the 20th century's greatest economists. If you took all of Mises' self-proclaimed followers and heaped them in a pile today, it wouldn't even reach to Mises' knee. It's too bad that he's not around today to say: "You guys are a bunch of goofs." You could say the same of Jesus, Mohammed, the Buddha, etc.

Such people account for 99% of gold standard advocates today. The number of people who could set up and maintain a proper, functioning system -- the mechanical engineers of money -- are extremely rare. Actually, it's really not all that complicated. We're going to need some people who know how to play this game, or otherwise, the game will never be played.

First off, it became apparent amidst the GOP primaries in 1980 that the Republicans would nominate a tax-cutting deregulator who was very public with his belief that no great nation long lacked a currency defined in gold. Ronald Reagan’s looming election arguably did much of Paul Volcker’s work for him.

Secondly, Europe was rapidly destabilizing. The Soviet Union had already invaded Afghanistan, and there existed the threat of it invading Poland. Worse for Europe, the French had recently elected a socialist who was known to be hostile to wealth. Reagan’s election joined with European turmoil, and the dollar was twice blessed as it were. The great ‘70s inflation effectively ended thanks to U.S. elections that occurred in concert with European uncertainty that made their currencies less attractive relative to the dollar.

Fast forward twenty years and uncertainty reigned once again. Though it’s fashionable now to date dollar weakness to last September when the Fed began reducing its rate target, true dollar weakness that revealed itself through rising gold and oil prices began in 2001. The tragedy that was 9/11 joined with rising protectionism, regulation and a war on terror to make undefined paper currencies less attractive relative to tangible items in an uncertain world.

All of this takes on even greater importance in light of the events which transpired on Friday. It is said by some that a surprisingly weak employment report told the story of the dollar’s fall, but with the influx of seasonal workers into the marketplace, it’s likely that at least part of Friday’s unemployment jump was already priced in. It also could be said that the report made further rate cuts likely, thus aiding the dollar’s fall, but with dollar weakness seven years old, and having occurred amidst rate cuts and rate hikes, it seems the direction of the Fed’s rate target is overrated as the cause.

Arguably the major reason for Friday’s commodity spike/dollar fall occurred far from the United States. Without getting into the good or bad of U.S. foreign policy, it’s fair to say that what happens in the Middle East strongly impacts the U.S. market/dollar outlook. At the very least it should be said that whatever our policies we’re a terrorist target, and when the Middle East flares up, the uncertainty greatly impacts our domestic outlook.

Along those lines, Pakistani officials on Friday announced that they had foiled a major terror plot that included bomb-laden vehicles and a number of potential suicide attackers. While the foiled plot would in theory be a dollar positive, the news perhaps reminded investors how dangerous the Middle East still is; the danger magnified in U.S. markets given our reliance on Pakistan to keep terror plots at bay.

In addition, Israeli Transport Minister Shaul Mofaz told a prominent Israeli paper that an attack was “unavoidable” if Iran continued to push forward its nuclear program. Due to the U.S.’s tight foreign-policy link with Israel, an attack by our ally on one of our enemies would in many ways be seen as an invasion countenanced by U.S. defense officials, and one that would eventually draw in U.S. troops. As an Agence France Press (AFP) story noted, Mofaz said such an operation could only be done with U.S. support.

To show the impactful nature of Mofaz’s comments on the dollar, we need only look at the price of gold in response to AFP’s release of the story at 3:36 am eastern standard time. As Bretton Woods Research chief economist Paul Hoffmeister wrote in a client piece, gold and oil markets began “to move slightly upward within 2 hours before 3:36 am, and then significantly higher after the AFP news report, sparking the dramatic upward trends throughout the day.” In short, the world became a much scarier place on Friday, and markets quickly adjusted the dollar to this uncertainty.

The dollar’s Friday collapse revealed yet again how unsuited our monetary policy is to a frequently unstable world. While the direction of the Fed funds rate has sparked much debate among those eager to see a stronger dollar, it should be said that these discussions are very much a non sequitur considering world events.

Even if rates are the valve through which the Fed injects dollar liquidity (many, including this writer, say that’s not the case), Friday’s events show how worthless the rate mechanism is in a world where currency demand shifts day to day, hour to hour, and minute to minute. Given the infrequency of FOMC meetings, any rate it sets can in no way synthesize the ever changing supply/demand of and for the dollar in such a way that the latter will achieve any semblance of stability.

That the rate mechanism is charitably feckless in an unstable world speaks to the importance of the Treasury and Fed adopting a price rule. Doing so would be a huge boost to the markets in that it would reveal to investors that the dollar’s value won’t be held hostage by events thousands of miles away.

Notably, Treasury Secretary Paulson did not rule out dollar intervention in a CNBC interview yesterday, and gold fell slightly. Rather than lightly hinting at a dollar fix, Paulson should recognize that the dollar is utterly insignificant except as a measuring stick that facilitates the wealth-enhancing exchange of goods.

Put simply, when the dollar is unstable so is the trade that is the basis of economic activity. So instead of waiting, Friday’s dollar activity should encourage Paulson to quickly announce a dollar/gold relationship that would insure currency stability while offering true “stimulus” to the economy. Indeed, in an uncertain and warring world, it’s essential that our economy be firing on all cylinders, free of inflation. Right now, that’s not the case.

But if Clinton and McCain were wrong, what should be done? One cannot simply ignore the pleas of those who are suffering. In the US, real middle-class incomes have not yet recovered to the levels attained before the last recession in 1991.

When George Bush was elected, he claimed that tax cuts for the rich would cure all the economy’s ailments. The benefits of tax-cut-fuelled growth would trickle down to all – policies that have become fashionable in Europe and elsewhere, but that have failed.

Tax cuts were supposed to stimulate savings, but household savings in the US have plummeted to zero. They were supposed to stimulate employment, but labour force participation is lower than in the 1990’s. What growth did occur benefited only the few at the top.

Productivity grew, for a while, but it wasn’t because of Wall Street financial innovations. The financial products being created didn’t manage risk; they enhanced risk. They were so non-transparent and complex that neither Wall Street nor the ratings agencies could properly assess them.

Meanwhile, the financial sector failed to create products that would help ordinary people manage the risks they faced, including the risks of home ownership. Millions of Americans will likely lose their homes and, with them, their life savings.

At the core of America’s success is technology, symbolised by Silicon Valley. The irony is that the scientists making the advances that enable technology-based growth, and the venture capital firms that finance it were not the ones reaping the biggest rewards in the heyday of the real estate bubble. These real investments are overshadowed by the games that have been absorbing most participants in financial markets.

The world needs to rethink the sources of growth. If the foundations of economic growth lie in advances in science and technology, not in speculation in real estate or financial markets, then tax systems must be realigned.

Why should those who make their income by gambling in Wall Street’s casinos be taxed at a lower rate than those who earn their money in other ways?

Capital gains should be taxed at least at as high a rate as ordinary income. (Such returns will, in any case, get a substantial benefit because the tax is not imposed until the gain is realised.) In addition, there should be a windfall profits tax on oil and gas companies.

Given the huge increase in inequality in most countries, higher taxes for those who have done well – to help those who have lost ground from globalisation and technological change – are in order, and could also ameliorate the strains imposed by soaring food and energy prices.

Countries, like the US, with food stamp programmes clearly need to increase the value of these subsidies in order to ensure that nutrition standards do not deteriorate. Those countries without such programmes might think about instituting them.

Two factors set off today’s crisis: the Iraq war contributed to the run-up in oil prices, including through increased instability in the Middle East, the low cost provider of oil, while bio-fuels have meant that food and energy markets are increasingly integrated.

Although the focus on renewable energy sources is welcome, policies that distort food supply are not. America’s subsidies for corn-based ethanol contribute more to the coffers of ethanol producers than they do to curtailing global warming.

Huge agriculture subsidies in the US and the European Union have weakened agriculture in the developing world, where too little international assistance was directed at improving agriculture productivity.

Development aid for agriculture has fallen from a high of 17% of total aid to just 3% today, with some international donors demanding that fertiliser subsidies be eliminated, making it even more difficult for cash-strapped farmers to compete.

Rich countries must reduce, if not eliminate, distortional agriculture and energy policies, and help those in the poorest countries improve their capacity to produce food.

But this is just a start: we have treated our most precious resources – clean water and air – as if they were free. Only new patterns of consumption and production – a new economic model – can address that most fundamental resource problem.

Joseph E Stiglitz is a Professor at Columbia University and the recipient of the 2001 Nobel Prize in Economics. He is the co-author, with Linda Bilmes, of The Three Trillion Dollar War: The True Costs of the Iraq Conflict.

Meanwhile, a few tenacious judges and prosecutors continue to work hard to unravel the offenses of the trial bar in the decades-long asbestos litigation frenzy, in which lawyers have ginned up phony diagnoses using compliant doctors, and paid kickbacks to union officials to recruit workers as plaintiffs. A few law firms have been fined for their misdeeds and one prominent lawyer has gone to jail. But that’s only after defendants have already paid out a staggering $70 billion in claims that wrecked dozens of businesses, cost thousands of workers their jobs, and enriched plaintiffs (many with no demonstrable health problems and no medical bills) and their lawyers--who’ve claimed more than half the awards in fees and expenses. As federal judge Denis Jacobs noted without a hint of irony, many of the claims in asbestos litigation are based on “fraud, corrupt experts, perjury, and other things that would be deplored and persecuted by the legal profession if done within other commercial fields.”

Critics of the trial bar, like Cardozo School of Law School Professor Lester Brickman, have been warning for years that the methods employed in asbestos litigation are too typical of a cadre of lawyers that has relentlessly pursued and dealt devastating financial blows to a series of industries, from construction firms to vaccine makers, to manufacturers of scientifically-proven safe products like silicon breast implants, to publicly held firms whose only offense was a sharp drop in share price. Still, you have to look pretty hard to find editorial outrage about the trial bar’s often dubious methods, or find calls for reform of our civil justice system from Washington that result in quick action.

Contrast that with the massive coverage and indignation over corporate misdeeds. When federal prosecutors indicted Enron CEO Kenneth Lay in 2004, newspapers responded with more than 1,000 stories in just a few days. When then-New York Attorney General Eliot Spitzer sued the New York Stock Exchange’s Richard Grasso over his rich pay and severance package, the New York Times alone reacted with 10 stories in less than a week--including a profile of Grasso’s attorney, an approving editorial encouraging Spitzer, an analysis of Spitzer’s legal strategy, and an op-ed column. Judging by the coverage, we Americans must particularly love a story of rich corporate guys getting hammered.

But the Grasso pay-package dispute, which is ongoing, mostly affected owners of the New York Stock Exchange, and even the collapse of Enron, which vaporized shareholder equity and cost thousands of employees their jobs, seems like small potatoes compared with the cost and consequences of illicit asbestos claims, which have helped to sink nearly 80 companies, including many which never used asbestos products.

But whereas Enron quickly produced the Sarbanes-Oxley Act, all the trial bar’s shenanigans seem to have shaped in Washington is more friendly legislation on their behalf. In the hopper now is the Energy and Tax Extenders Act of 2008, which includes a provision to allow plaintiffs’ attorneys to deduct upfront from their tax bill the expenses of pursuing a case on a contingency-fee basis. The effect will be to help free up more up-front money for trial lawyers to pursue contingency fee cases in what is already one of the world’s most litigious society.

It would be tempting to explain all of this simply by noting that trial lawyers use the deep pockets they’ve acquired through our litigation system to spread around massive amounts of campaign contributions, buying friends and influence across the political spectrum, especially among Democrats (it was former San Francisco Mayor Willie Brown who once referred to the plaintiffs’ bar as one of the ‘anchor tenants’ of the Democratic Party).

But the causes go deeper. The direct victims of the trial bar are mostly deep-pocketed institutions like companies, governments and big nonprofits (hospitals, for instance) that hardly elicit much sympathy from the press, even when they collapse from the weight of litigation. The trial bar has also been skillful in building alliances with (and often funding) consumer advocacy groups that often lead the publicity charge about some new and dubious woe that the lawyers will eventually target for lawsuits, like “toxic” mold in buildings.

And trial lawyers have been skillful at cultivating the press, often providing them with scoops in advance of their lawsuits. It was a trial firm, for instance, that originally provided the New York Times with transcripts of a tape of a meeting of Texaco managers which purported to show them using racial epithets. Publication of the story eventually prompted a firestorm of publicity and led to lawsuits against the company. Only later did audio experts, analyzing the garbled tapes, determine that the transcripts provided by the trial firm were inaccurate and the managers had uttered no such racial slurs. By then, a worried Texaco had already settled out of court and most of the press had forgotten the case.

Facing an industry this skillful at public relations, the real reform of our civil justice system is happening slowly, on a case-by-case basis, prompted by a few judges and prosecutors outraged at the practices of the trial bar. Since judges started looking more carefully at the claims in asbestos mass tort cases, in which thousands of plaintiffs are linked together and their medical records merged into one vast presentation, the waves of claims have magically begun disappearing, plunging by 95 percent. Now, the cases going forward are largely those of people who have actually suffered harm. We once though this was the way our civil justice system was supposed to work, before we let the trial bar turn it into their personal piggy bank.

The Spence report represents a watershed for development policy — as much for what it says as for what it leaves out. Gone are confident assertions about the virtues of liberalisation, deregulation, privatisation, and free markets. Also gone are the cookie cutter policy recommendations unaffected by contextual differences. Instead, the Spence report adopts an approach that recognises the limits of what we know, emphasises pragmatism and gradualism, and encourages governments to be experimental.

Yes, successful economies have many things in common: they all engage in the global economy, maintain macroeconomic stability, stimulate saving and investment, provide market-oriented incentives, and are reasonably well governed. It is useful to keep an eye on these commonalities, because they frame the conduct of appropriate economic policies. Saying that context matters does not mean that anything goes. But there is no universal rulebook; different countries achieve these ends differently.

The Spence report reflects a broader intellectual shift within the development profession, a shift that encompasses not just growth strategies but also health, education, and other social policies. The traditional policy framework, which the new thinking is gradually replacing, is presumptive rather than diagnostic .

It starts with strong preconceptions about the nature of the problem: too much (or too little) government regulation, too poor governance, too little public spending on health and education, and so on. Moreover, its recommendations take the form of the proverbial "laundry list" of reforms, and emphasise their complementary nature — the imperative to undertake them all simultaneously — rather than their sequencing and prioritisation. And it is biased toward universal recipes — "model" institutional arrangements, "best practices," rules of thumb, and so forth.

By contrast, the new policy mindset starts with relative agnosticism about what works. Its hypothesis is that there is a great deal of "slack" in poor countries, so simple changes can make a big difference. As a result, it is explicitly diagnostic and focuses on the most significant economic bottlenecks and constraints. Rather than comprehensive reform, it emphasises policy experimentation and relatively narrowly targeted initiatives in order to discover local solutions, and it calls for monitoring and evaluation in order to learn which experiments work.

The new approach is suspicious of universal remedies. Instead, it searches for policy innovations that provide a shortcut around local economic or political complications. This approach is greatly influenced by China's experimental gradualism since 1978 — the most spectacular episode of economic growth and poverty reduction the world has ever seen.

The Spence report is a consensus document, and therefore an easy target for cheap shots. It has no "big ideas" of its own, and at times it tries too hard to please everyone and cover all possible angles. But, as Spence puts it with regard to economic reform itself, you need to take small steps in order to make a big difference in the long run. It is quite a feat to have achieved the degree of consensus he has around a set of ideas that departs in places so markedly from the traditional approach.

It is to Spence's credit that the report manages to avoid both market fundamentalism and institutional fundamentalism. Rather than offering facile answers such as "just let markets work" or "just get governance right," it rightly emphasises that each country must devise its own mix of remedies. Foreign economists and aid agencies can supply some of the ingredients, but only the country itself can provide the recipe.

If there is a new Washington consensus, it is that the rulebook must be written at home, not in Washington. And that is real progress.

Dani Rodrik is Professor of Political Economy at Harvard University's John F. Kennedy School of Government. His latest book is One Economics, Many Recipes: Globalization, Institutions, and Economic Growth.

This week we were given the data that inflation as measured by the Consumer Price Index (CPI) over the last year was 4.2% and unemployment is now 5.5%. Some call for the Fed to raise rates so that we do not have to experience another lost decade like the '70s and then ultimately see some future Volker forced to raise rates and drive unemployment back to 10%. Others suggest that "core" inflation is what should be paid heed to, and urge caution.

This week we look at the cost of what could be a renewed effort to Whip Inflation Now, not just here but in countries worldwide. Will Trichet in Europe raise rates even as the European economy seems to be slowing down? If you think inflation is bad in the US and Europe, take a peek at Asia. And I ask, "What will Ben do?" It should make for an interesting letter.

Whip Inflation Now

Nixon and his advisors thought inflation at 4% was serious enough to institute price controls. Headline inflation in the US is now 4.2%. What kind of economic policy should we pursue to bring inflation back into the Fed's comfort zone of 1-2%? Would it work and would it be worth the pain? To get a handle on the question, let's go to the data from the Bureau of Labor Statistics and see where inflation is coming from.

And let me note, this is the same exercise we could do for a host of countries. The answer will be roughly the same: there are no easy solutions.

Core inflation, or inflation without food and energy, grew at 2.3%. Inflation without food costs was an even 4% and without energy was 2.7%. Clearly energy was the leading contributor to inflation in the past year.

But the recent trend in rising inflation is even more worrying. If you look at just the last three months of data and compute an annualized rate of inflation, you find that overall inflation has risen to 4.9%, energy inflation is running at a staggering 28%, and food costs have risen 6.2%. Meanwhile, core inflation during that period dropped to 1.8%. You can see all the data at http://www.bls.gov/news.release/cpi.nr0.htm.

Now, gentle reader, let's think about these numbers. Food (over 14%) and energy (over 9%) combined make up roughly 24% of the CPI, yet were responsible for over 60% of the recent three-month trend in inflation. By the way, housing was up 4.9% and transportation up 8.7%, so it was not just food and energy.

What would it take to drop headline inflation back to under 2%? Well, one way would be for food and energy prices to fall. Let's look at the possibilities.

As Donald Coxe has noted, North America has had an 18-year run of remarkably good weather in our growing season. You have to go back 800 years to get a string of years that were that good. Yet today food reserves of all types are at decades-long lows. There is very little room for any type of problem.

This growing season is not off to a good start. It looks like the yield on the corn crop will be lower than normal, and that is if we get very benign weather this fall. Given how late much of the US corn crop was planted, and how torrential rains in the corn belt have devastated crops (not to mention flooding cities, and our thoughts and prayers go out to those who have lost their homes to flooding), an early frost would be disastrous.

Because we have devoted so much of our arable land to corn (in a very misguided policy to turn food into ethanol), we have less for soybeans, which is putting upward price pressure on beans and other grains that are used to feed cattle, hogs, chickens, etc. In fact, it costs so much to feed livestock that ranchers are shrinking their herds.. This means more meat is coming into the system now, which is dampening prices. Increased supply will reduce prices in the short term, but next fall we will find that supplies of all types of meat will be short. That will potentially send meat prices soaring. Cereal and bakery products are up 10% over the last year. They could continue to rise in the fall if the corn crop does not yield more than currently projected. It will cost even more to feed your household and feed the animals we need for meat.

Food is the most basic of commodities. Demand is fairly consistent, and supplies may come under pressure. Looking for food inflation to drop back by the fall to 2% is not realistic in the current environment.

What about energy? There is some more hope there, at least on the oil front. High prices have reduced demand in the US, with gasoline usage down about 4%.

I think we have reached a tipping point. The psyche of the US consumer has been permanently scarred. Slowly, this country is going to replace its fleet of cars with smaller, more fuel-efficient cars. Over time, we will see demand continue to fall. We could see further drops in the demand for gas in the next few months.

Much of Asia used to subsidize oil prices to their consumers. That is changing, as Indonesia, Sri Lanka, and Taiwan have announced they are decreasing their subsidies, as the cost is simply too much. Malaysia now spends 25% of its budget on oil subsidies, and must raise prices or cut other services - or watch inflation get worse. India is now contemplating how to cut its subsidies. Even China is likely to start to raise costs after the Olympics. These countries are going to go through their own price shocks. All this will reduce world demand for oil.

And while there are those who are convinced the high price of oil is due to speculators, there are reasons to think the real culprit is still demand. Refiners are paying anywhere from $5-7 more per barrel than futures prices for "light sweet" crude (oil with low sulfur content) and $7 less for heavy sour crude. Much of the oil from the Middle East is of the latter variety, and supplies are increasing. There is not enough refinery capacity for heavy sour crude. That is why you see OPEC representatives say there is enough supply. For the crude they produce, there is. Spot prices are reacting to supply and demand and not speculative futures prices.

Over time, reducing demand should reduce price. I would expect to see oil get back to $120 or lower by the end of the year. But by year-over-year comparisons, inflation will still be ugly for some time. Oil prices have risen approximately 90% in the last 12 months (the actual percentage is highly dependent upon which measure you use). The bulk of that has been in the last four months. For energy inflation to go down on a year-over-year basis, we would need to see oil drop below $100. How likely is that in the next two quarters?

Where Can We Get Help on Inflation?

So, the two main sources of inflation are unlikely to drop in the next two quarters. If we want to get overall inflation down to 2%, we will need to look for help in other areas of the economy. How about medical care? Not likely. Education costs? Get real.

Housing costs make up 42% of the CPI, and thus are the biggest component. That is broken down into several categories: owners' equivalent rent for those who own their homes (32%), actual rent for those who do not (around 6%), utilities, furnishings, etc.

Rents have been up by 3.5% over the last year and owners' equivalent rent by 2.6%. If rent increases were to drop to zero, that would just about get us to 2% overall inflation. But let's think about that. Such a low number would mean an economy on its heels and a lack of buying power on the part of consumers. The only way that happens is with serious unemployment.

You can go to http://www.bls.gov/news.release/cpi.t01.htm and look at the various components of the CPI. Spend some time thinking about what costs are likely to drop. New and used vehicles are now dropping year over year, but only by a little, and that is only 7% of the index. Most items are rising at least a little.

Now, in a second thought exercise, think about what would happen if Bernanke decided to raise rates. A rising Fed funds rate is unlikely to have much effect on oil or food prices, unless he raises them enough to put the US and world economies in a serious recession.

How much would he have to raise rates to really slow the rest of the economy down? If you push up rates by 2% with the economy either in recession or close to it, you risk putting the economy into a much deeper recession.

Look at the yield curve below. This is exactly what the banks and financial services lend. They like to have a nice positive differential between the cost of their deposits and what they can charge for lending.

If you raise rates by 2%, you would more than likely invert the yield curve, making it that much more difficult for financial service companies to be able to recover. Given that they are already in trouble, and therefore less able to lend to businesses and consumers, do you really want to make things worse?

Look at the banking index below. This is an ugly chart. Another inverted yield curve would do serious damage to an industry already reeling. We are going to see more write-offs from banks. This chart will get uglier, but it will collapse without a positively sloped yield curve. (chart courtesy of www.fullermoney.com)

Further, raising rates would make it more difficult for consumers whose mortgage rates are tied to short-term rates. Is that what a housing industry needs right now?

Bottom line, Bernanke is in a very difficult position. Inflation by any standards is too high. But the cause of the inflation is not something in the Fed's control. To bring inflation back to 2%, he would have to savage the economy, perhaps at least as much as Volker did. Do you want to see unemployment go to 8-10%?

Volker was dealing with wage inflation. Everything had cost of living adjustments (COLAs) back in the late '70s and early '80s. Spiraling wages were one of the primary causes of inflation, if not the most important. A higher Fed funds rate could do something about rising wages by increasing the unemployment rate. Tough love, but effective.

Volker had to kill inflation expectations. Today, that is not (so far) Bernanke's problem. If you look at the implied inflation in the TIPS market, which is the difference between a ten-year treasury note and the ten-year TIP rate, it has only risen from a recent low of 226 bps on May 1 to 249 bps on June 10. Look at the following chart from Asha Bangalore of Northern Trust. Note that inflation expectations are not at recent highs.

The Patient Died Anyway

An expected inflation rate of 2.5% is well within "contained." It would be irresponsible to put the economy into a serious recession under such a set of circumstances. My Dad had a saying, "The operation was a success, but the patient died anyway." Raising rates in any serious manner would whip inflation but would kill the economy at this point. Rates will need to go back up at some point, but not until the economy shows signs of a rebound. I think the chances of the Fed raising rates by the 75 basis points, by January, that the market has priced in, is quite low.

What will happen is that over time the annual comparisons will begin to be less problematic. The cure for high prices is high prices, as the true cliche goes.

Sadly, we may get some help on the housing inflation component. Foreclosure filings last month were up nearly 50% compared with a year earlier. Nationwide, 261,255 homes received at least one foreclosure-related filing in May, up 48 percent from 176,137 in the same month last year and up 7% from April, foreclosure listing service RealtyTrac Inc. said Friday.

The prices of homes in many areas are going to fall to the level at which they can be rented. As more homes come onto the market for rent, the pressure on rent prices will fall. And the measure of owners' equivalent rent will fall along with it. Mark Zandi, chief economist of Moody's Economy.com (and an adviser to Republican John McCain's campaign), wrote earlier this week that "the Bush administration's efforts to encourage loan modifications and delay foreclosures are being completely overwhelmed."

Separately, a Credit Suisse report from this spring predicted that 6.5 million loans will fall into foreclosure over the next five years, reaching more than 8 percent of all US homes. (AP) That is going to keep pressure on housing prices for several years at the least.

Thus, it is likely that Bernanke and company will continue to talk tough on inflation. But, as noted above, I also doubt that they will raise rates this year, and probably not until well into the next.

The only reason to raise rates would be to protect the dollar from a serious collapse. I think it more likely the Treasury would intervene in the markets to prevent such a collapse. Dennis Gartman, at dinner Wednesday night, suggested that if the administration really wanted to get the market's attention, they could intervene in the currency markets and release oil from the Strategic Petroleum Reserve at the same time. While it would only be a temporary fix, it would make speculators nervous. However, they might consider such an experiment preferable to having the Fed raise rates during the middle of a slowdown/recession.

And the dollar seems to have found at least a temporary bottom, and we could see further strengthening next week, as Ireland voted today to reject the proposed European central government. Since it takes an absolute 100% consensus among all member nations, that kills the deal. Europe now has a very odd shape. They have a commercial union. Some of the members share a currency. Some of them share actual membership in the EU. Some of them are in NATO. They have competing and very different needs for monetary policy.

In fact, it will be hard to get anything done in Europe apart from commercial treaties, etc., as any one country can veto any particular item which is not to their advantage. Over time, this is going to be seen by the world as an issue for the euro. And given the demographic and pension problems of "Old Europe," the currency is going to come under increased pressure from competing needs for funding, taxes, and an easy monetary policy.

Six years ago I talked about the euro rising to $1.50, but I also noted that by the middle of the next decade it is likely to come back to par. We are halfway on that journey, and I still think we will arrive at my predicted point.

I think it is possible that the dollar could rise 10% or more this year against the euro, which would help inflationary pressures. Import prices into the US are up 17.8% year over year. A stronger dollar will help alleviate that.

Inflation in Asia and Europe

Countries throughout Asia would love to have a 4.2% inflation rate. Indonesia is at 10.4%, almost twice what they were a year ago. Vietnam would love to have such mild inflation, as its own level is up over 25%. Inflation in China is 8%. Inflation is up throughout the continent. And oil and food are the culprits.

Korea is particularly strained. Korea has seen its import prices rise by almost 45% in the last 12 months. Read this note from Stratfor:

"South Korea is among the most vulnerable of Asia's top economic players to global price increases due to its heavy reliance on imports for many of life's basic essentials - including oil, wheat, corn and coarse grains. At least 96 percent to 100 percent of its annual consumption in each of these items is imported. With global supplies in these basic necessities set to tighten, South Korea's inflation and the associated social unrest can only rise. (Protests in South Korea can draw hundreds of thousands of marchers.)

"Interest rate hikes are one of the most readily available tools for fighting inflation and for propping up a weak currency. In theory, raising rates would help attract foreign money into South Korea by raising the rate of return on investments in the country, thus helping to increase the value of the local currency and to contain rising energy import costs and inflation. But just June 12, South Korea's central bank decided to keep interest rates frozen at 5 percent. This was because the potential economic slow-down an interest rate increase could trigger is too politically risky for the government, and because there are less controversial means to bolster the won.

"If interest rates were raised to tackle the problem of increasingly expensive imports, the access of Korean businesses and households to credit to fund their operating costs or mortgage payments would shrink. This would make the government of President Lee Myung Bak even less popular."

What to do? Each country will try its own particular witch's brew. China is raising interest rates, increasing bank reserves, and allowing its currency to continue to rise. But make no mistake, there are no easy answers. Each choice has its own unintended consequences.

But a large part of the problem in Asia is food and energy. And monetary policy alone cannot address world supply imbalances. To a greater or lesser degree, every country is faced with the same conundrum. Do you risk higher unemployment and your economy to fight inflation that is not strictly speaking a monetary problem? If food is rising 40% in Vietnam, its workers will have to make more in order to eat? Will such a price increase force higher wages and perhaps a wage increase spiral like the US saw in the '70s? If you increase the value of your currency too fast, you risk losing your competitive price advantage and thus losing business and jobs.

There Are No Good Solutions

Over in Europe, I noted last week that one Jean Claude Trichet, the president of the European Central Bank, virtually promised the markets a series of rate hikes. This sent the dollar into the tank and the euro back to new highs. Gold loved it.

But this week has seen a very unusual set of speeches by fellow ECB members disavowing Trichet's promise, and even Trichet had to try and "explain" away what he had said. "We aren't talking about a series of rate hikes. Maybe, just possibly, we would raise in the event of more inflation." Confusion reigns. There is clearly not consensus at the ECB.

You can bet Trichet heard from various finance ministers in the countries whose economies are weakening. They are not interested in a stronger euro or higher rates. What one person called the PIGS countries are surely objecting (Portugal, Italy, Greece and Spain, whose economies are not exactly robust).

And their objections are the same ones that would be made here. What good would a rate hike do? How much more oil or corn would be produced? Why increase our pain when there could be no positive result?

The central banks of the world got by for years with easy monetary policies (think Greenspan) because of rising productivity, cheap energy, increased international trade, a disinflationary environment because of cheap Asian labor and imports, etc. Now that economic regime has come to an end. Stability had bred instability in a very uncomfortable Minsky Moment.

There are no good solutions. There will only be a choice of how much and what type of pain. The US, Europe, and Japan are entering Muddle Through World. The rest of the world is faced with increased volatility. This is a tough environment in which to be a central banker.

More realistically, Americans are not only great savers, but they’ve been successful investors too. The capital gains that have often been the reward for past parsimony doubtless lead to some of the decadence that Brooks decries, but they certainly aren’t indicative of a nation that has embraced spending over saving.

That Americans are also bombarded with saving opportunities in the mail, on television and in countless financial publications similarly doesn’t speak to a profligate nation. If Americans didn’t save there would be no reason to shower them with ads touting same, not to mention that financial services firms such as Merrill Lynch and Citigroup would have no reason to employ tens of thousands of investment professionals.

Naturally Brooks bemoans what he deems “soaring” credit card debt, but in so doing, he ignores the anecdotal. It’s unlikely that he would lend money to those lacking the ability to pay it back, and with credit-card companies under the thumb of investors (more on that later) seeking high returns, it’s folly to assume that they blindly lend without developing a strong sense first of the potential debtor’s wherewithal to make payments. Simply put, it’s precisely because Americans are so financially sound that lenders are so eager to lend them money.

Brooks notes that “fifty-six percent of students in their final year of college carry four or more credit cards,” and while that’s an excitable revelation at first glance, it ignores the obvious. No doubt college students take on a lot of debt, but by virtue of a college degree that correlates well with future financial success, lenders once again deem this class of borrowers worthy when it comes to paying back that which is owed.

Furthermore, Brooks doesn’t distinguish between college-age debts of the spring-break trip variety versus liabilities incurred that will pay off in the future. Sure enough, many college students borrow in the present to pay for presentable work clothes, computer technology and geographical relocation that will over time make any initial pain that results from high monthly payments seem miniscule by comparison.

Perhaps due to his own success as an intellect and a saver, Brooks decries lottery products which according to him are referred to by some as “a tax on stupidity.” It says here that lotteries are unfortunate for re-orienting potential savings into government consumption, but it should also be said that those at the bottom of the economic scale are very much a moving target. In short, there are future billionaires among today’s lottery-ticket purchasers.

When we consider the “Payday” lenders that Brooks denigrates, it would be more realistic to say that they’re merely a facilitator of “high yield” financing for those who can’t access traditional lines of credit. That Brooks thinks churches should do what Payday lenders do is an arrogant comment which presumes lending is easy. Furthermore, far from predators, Payday lenders proliferate thanks to them filling a previously unmet market need.

Most bothersome about Brooks’s column, however, was his comment about hedge-fund managers. After correctly lauding Bill Gates for his success in silly terms (Gates is good for creating a “socially useful product”), Brooks asked, “what message do the compensation packages that hedge fund managers get send across the country?”

First off, it should be said that no one forces individuals and institutions to invest in hedge funds. That investment experts choose to do so anyway strongly suggests that hedge funds offer enormous value to investors. Engaging in great simplification, hedge-fund managers offer investors total returns in any kind of market; something very useful considering that the S&P 500 has been flat for the last nine years.

But since Brooks seems to view success through the prism of that which is “socially useful,” it should be said that hedge funds bless the economy whether they’re long or short. Their investment success aids the economy when they’re long for them properly moving capital to its highest and most profitable use. Similarly, they aid the economy when they’re short for successfully betting against a certain company or sector. Indeed, their being short speeds the process whereby the markets acknowledge that capital is being misused, and as such, is redeployed elsewhere to some sector/company that will utilize it more efficiently.

And when we consider the twenty percent of Americans that apparently fall into the stupid category, many are shareholders in pension funds; those funds often the vehicle through which the masses achieve market exposure, including to hedge funds. Hedge-fund managers only earn large pay packages after they’ve created enormous returns for their shareholders. Brooks presumably ignored that reality while slandering the industry’s greatest successes.

Brooks is certainly correct in arguing that the “tax code should tax consumption” over income, but as most commentators have done in recent years, he ignores one major reason consumption is so high: the weak dollar. Americans in general have had large incentives to consume rather than save money due to the latter. If/when the dollar’s value is strengthened and made stable, Brooks can rest assured that Americans of all stripes will soon enough rediscover their interest in the stock market.

Brooks ultimately bases his debt-seduction argument on the mythical notion that Americans don’t save; a notion certainly belied by all the wealth in this country and all the debt that Americans are allowed to incur. In his defense, however, there is a savings problem, but right now that problem results from a weak dollar that he failed to mention

Because Mr. Forbes is correct in saying that the only way out of our current economic and financial chaos is for the Fed to stabilize the dollar, two points must be made:

1. The old gold standard did, in fact, cause the Great Depression.
2. This fact should not discourage the Fed from establishing a modern gold standard.

In his 1991 book, Golden Fetters—The Gold Standard and the Great Depression 1919–1939, author Barry Eichengreen gives an excellent “play by play” account of the rise and fall of the old gold standard. His thesis is that the “classic” gold standard of 1880 – 1913 worked well, but the “interwar” gold standard of 1925 – 1931 was doomed from the start.

Golden Fetters is a work of great scholarship, but I believe that it misses the most fundamental flaw of the old gold standard—that it was based upon a lie.

One of the laws of the universe is, “Without integrity, nothing works”. A corollary is, “At the core of every business (or economic) disaster is a lie.” The Great Depression was the greatest economic disaster of all time, so at the heart of it had to be an enormous lie.

The old gold standard was based upon the collective promise of the participating governments to redeem their currencies for gold at a fixed price upon demand. From the beginning, there wasn’t enough gold in the world to honor this promise. This was the fundamental lie.

The lie was implemented via “fractional gold coverage” laws that allowed central banks to issue (typically) up to 2.5 times as much base money as the value of their gold holdings. Then fractional reserve banking was used to leverage the monetary base to create even more money. When the game of “let’s pretend” being played by governments, central banks, financial institutions, and the public collapsed, so did banks, employment, trade, and the gold standard itself. Because gold was the only real money, when the crunch came, everyone wanted to redeem their money for gold—at the same time.

So, why base the world’s monetary system on a lie? Why not just use 100% gold coverage for the monetary base and 100% reserve banking? The answer is, “because the resulting deflation would have been politically intolerable”. As the world economy became more differentiated, productive, and complex, there was a need for more and more money. Despite the many “tricks” described in Golden Fetters that were employed to “stretch” the available gold, the old gold standard was marked by chronic deflation. The U.S. GDP Deflator was more than 17% lower in 1929 than it was in 1920. When the “stretched” world money supply finally “snapped” in late 1929, the deflation accelerated, with the price level plummeting another 26% by 1933.

What the world learned from the old gold standard is that you cannot use anything physical as money and maintain integrity. Any commodity that is valuable enough to start using as money will be too scarce to continue using as money.

Today we have the “Bernanke Standard”. Like many other “fiat money” regimes around the world, the Bernanke Standard is also based upon a lie. In this case, the lie is that “money” and “capital” are the same thing, and that it is possible to regulate the value of money by manipulating interest rates. They are not, and it is not.

Since March, 2001, the dollar has lost about 70% of its real value, whether measured against gold or retail gasoline. During that time, the Fed lowered its Fed Funds interest rate from 5.00% to 1.00%, raised it to 5.25% and then lowered it to 2.00%. Clearly, there is no direct relationship between the Fed Funds rate and the value of the dollar. But why would there be? The Fed Funds rate is the price of a certain type of short-term capital, and capital is not the same thing as money.

Because, “Without integrity, nothing works”, the only way out of our current mess is to restore integrity to the dollar. We must have a monetary system that is not based upon a lie. A “modern gold standard” would do the trick.

Under a modern gold standard, the Fed would use its Open Market operations to force the COMEX price of gold down to (say) $500/oz and keep it there. At that point we would have a fiat currency whose value was defined in terms of the market value of gold. Unlike the old gold standard, gold would not be money, and monetary operations would not create any additional demand for gold. The monetary base would automatically expand and contract in response to market demand. Because the Fed has the power to deliver on a commitment to stabilize the value of the dollar against gold, a modern gold standard would have integrity.

Under a modern gold standard, the world would be certain of future value of the dollar. All of the economic costs currently devoted to hedging fluctuations in the value of money would be avoided. Interest rates would fall. The economy would boom. Crude oil prices would fall from today’s $134/bbl to $77/bbl—or less.

If we restore integrity to the dollar, our economy will start working again and the current climate of fear and anxiety will abate.

Even allowing for a certain amount of predictable chauvinism on the part of local politicians, the angry reaction to InBev’s bid is another example of how the public discussion in the United States about globalization seems increasingly to be a one-way debate—it’s almost all bad for us. U.S. companies are discouraged from outsourcing jobs and from importing too much cheap foreign merchandise to sell here. And now foreign businesses are to be resisted when they want to invest in the U.S. by snapping up a local company and in the process enriching shareholders and distributing our goods worldwide, as InBev wants to do. Indeed, even as InBev was launching its bid last week, U.S. Commerce Secretary Carlos Gutierrez was being excoriated on the opinion pages of the Washington Times for urging businesses in China to invest in America in the same way American firms are investing in China. For that, apparently, Gutierrez was deemed guilty of favoring “corporate globalism” over “economic nationalism.”

The good news is that the foreign investment boom in the U.S. is in full swing anyway. Earlier this month, the U.S. Bureau of Economic Analysis reported (virtually without notice by the press) that foreigners invested some $277 billion in the country in 2007, including $255 billion for acquisitions of U.S. businesses and $22 billion to start up new firms here. That was the second highest total ever and represented a more than five-fold increase since 2002, when investments in the United States slumped after 9-11.

Although some of the increase in foreign investment is attributable to the decline in the dollar, which has made it a bargain for foreigners to acquire American firms or start-up new businesses here, the real source of the gain, which included a 67 percent growth in investments in just the last year, is the long-term confidence that many foreign firms have in the U.S. economy. Even as our press and the presidential campaign are filled with talk that Americans are worried about their economic future, the BEA numbers show that overseas investors are betting heavily on the United States.

Some of the increase in investments is coming from companies in developing countries, like India, where economic growth has been so rapid that firms are now global players. Earlier this year, for instance, India’s Tata Group agreed to buy Land Rover and Jaguar operations from Ford Motor Co. for $2.3 billion, taking these troubled divisions off a struggling Ford’s hands. Tata’s purchase alone is more than double the total amount invested by Indian companies in the U.S. back in 2000, the peak year for overall foreign investment in America. This growth in Indian investment in the U.S. should be viewed as one of the payoffs of globalization.

Instead, the global economy is viewed here increasingly as a one-way street. While InBev’s bid for Anheuser is excoriated, the management at the American beer maker is cheered for considering buying up a controlling stake in Mexican brewer Grupo Modelo, which would create an entity too big for InBev to swallow. None of the opponents of InBev’s bid apparently see the irony in an American company resisting a Belgian firm’s takeover by purchasing a Mexican business.

I used to believe that opponents of expanding global trade wanted (unrealistically) to send us back to the 1950s, that brief period when American manufacturing reigned supreme in a world in which Europe was still recovering from World War II and developing countries lacked the wherewithal to compete globally. But the more the anti-global debate proceeds the more it seems like the ideal world for so many proponents of ‘economic nationalism’ is in fact a kind of 17th Century neo-mercantile environment in which America is free to export all it wants but wields a trade policy that discourages imports and foreign investment here. That would satisfy those who want their Bud to be home-grown, at the cost of a lower standard of living for most of us.

So far as I know, there is no new news coming out of Israel. Today’s Times story is a look backwards.

But I want to make a separate point. Oil-market traders react rationally to new information. Instead of blaming them, senators McCain and Lieberman might want to visit with some traders on some of the big Wall Street trading floors to better understand the relationship between global news and price discovery.

There’s something more here. Democrats reading from their talking points are completely opposed to Bush and McCain proposals to open up new oil drilling offshore and onshore. The Democratic argument — which I heard again last night on my show from Robert Reich — is that it will take ten years to lift new oil, which will never help today’s price problem. Obama says exactly the same thing, as do Harry Reid, Nancy Pelosi, and all the rest. But they’re forgetting the role of oil traders.

Oil futures markets have contracts that run out five years and beyond. If these traders — or “speculators” — believe new oil supplies are on the way in the future, they will sell those out-year contracts. And before long market arbitragers will backward-ize those price drops toward the spot market, bringing prices down there as well.

In other words, trader/speculators can be very handy instruments of energy (and economic) policies. If demand exceeds supply they are buyers. But a prospective future supply increase makes them sellers. In a free market prices move both ways. And if Sen. McCain would take the time to learn this he could respond accordingly to Obama’s silly criticism that we shouldn’t drill because it will “take too long.”

This is all part of the key point that McCain can turn record energy prices to his political advantage, as polls now show 65 percent, or two-thirds, of the public favors drilling. But to do this the whole GOP must understand the role of oil traders and their speculations.

We sent an email to some of you a few days ago, asking you to fill out a survey to help us gather data, with the intention of sending it to everyone over time. After you complete this survey, I offer an audio stream of a speech I recently made.

The survey software we're using had been stress tested to handle 50,000 surveys in a 24-hour period. For whatever reason, though, the server on which the survey was hosted simply collapsed under the number of people trying to complete the survey and listen to the speech.

I am sorry about the frustration some of you had not being able to get into the survey. We are working on getting the problem fixed and will send an email out sometime next week with a properly working link. I am really quite excited about this project, as we will all learn a lot, Tiffani and I most of all. Thanks for your help, patience, and indulgence.

Warren Makes a Bet

The Motley Fool did a foolish thing and made me one of five nominees for Investor of the Year for 2007. Warren Buffett of course won, but I was surprised (as was The Motley Fool) that I came in second. Buffett is the clear winner in investing, and his wisdom is followed by a large legion of fans, among which I am one. So, let me get myself in trouble and disagree with him on a small matter.

Carol Loomis (one of my favorite financial writers) writes in this week's Fortune about a bet that Warren Buffett made with a hedge fund management company. You can read the fascinating story at Fortune: Buffet's Big Bet. Quoting:

"And to that there is a certain history, which began at Berkshire's May 2006 annual meeting. Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking."

A New York firm, Protege Partners, which manages $3.5 billion in a fund of hedge funds, decided to accept that bet. Basically, Buffet and Protege each put $320,000 into 10-year zero-coupon Treasury bonds that will be worth $1 million in 10 years. The bet is straightforward. Protege has chosen five funds of hedge funds, and these funds must return more than the S&P 500 over the 10 years beginning January of 2008. (The list of funds is a secret.) The winner gets the $1 million donated to their favorite charity.

Which way would you bet? If the online response at Fortune is any indication, 90% of you would bet with Warren. As one enthusiastic responder wrote, "How can you bet against Buffett? I'd bet my life savings on it ..." Well, Tom, you might want to hedge your bet. Even Warren said he thinks his odds are only 60%.

The basic premise to Buffett's position is that the high fees simply eat up any potential for extra profits, over those of a simple index fund. As Buffett writes:

"A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds."

And he is right about the fees. Hedge funds, and especially funds of funds, must do much better than average to overcome their high fees. Loomis sums it up as follows:

"As for the fees that investors pay in the hedge fund world - and that, of course, is the crux of Buffett's argument - they are both complicated and costly. A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

"So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones 'bought' by Buffett in the bet.

"On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the 'helpers' that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

"The summation is pretty obvious. For Protege to win this bet, the five funds of funds it has picked must do much, much better than the S&P."

True. But the growth of hedge funds and fund of funds suggests that some think there is value there that is worth the fees. But let's set aside that argument for now, and look at the prospects for the bet between Protege and Buffett.

It's All About Values

As I wrote in Bull's Eye Investing (Amazon.com) and occasionally stress in my writing, the long-term returns you get from index fund investing are very highly correlated with the P/E (price to earnings) ratio at the time you make your initial investment. The P/E is price divided by earnings. If the ratio is 10, then earnings are about 10% of the stock price. If the ratio is 20, they are about 5% of the stock price. The higher the price, the less earnings you get for your invested dollar. However, a rising P/E ratio can be a major boost to stock market returns.

If you make your investment when valuations are low, you return is going to be much higher over time than if you make your investment when valuations are high. Look at this graph from South African partner Prieur du Plessis of Plexus:

Prieur divided the S&P 500 into five groups based on the initial P/E ratio and then calculated what the returns would be for the next 10 years, after inflation. He also used a 10-year average of the P/E ratio, to take out the fluctuations caused by one-off events, recessions, etc.

As you can see, and long-time readers should expect, if you invest when stocks are at their cheapest, you can make a remarkable 11% on average for the next 10 years after inflation. As stocks get more expensive in terms of their P/E, returns begin to fall. Real returns for the last group are only 3.2% on average.

We are currently in the range of the highest valuations. If you make the generous assumption that inflation will be 3% over the next decade, you are talking about a 6% total return, based on historical averages. Not bad, but not what a lot of investors are hoping for. Remember that 6% number, as we will revisit it in a moment.

One of my basic premises is that we need to look at markets in terms of valuation and not just price. Markets go from high valuations to low valuations and back to high. The round trip can take the better part of 30-40 years. These are long-term secular markets, and they are mean-reverting. By that I mean that markets will go both well above and well below the long-term mean average over time.

To see how well correlated long-term returns and P/E ratios are, you can go to www.frontlinethoughts.com and click on the link where it says "get the stock market graphs here" on the upper right-hand side. You can see what your returns would have been in any period of time since 1900. Then check at the top to see what the P/E ratio was at that time. If the return numbers are white, then P/E ratios were falling and returns were either negative or low. When the numbers are black, that means P/E ratios were rising, and returns are also likely to be good.

Look at the following charts from Vitaliy Katsenelson (author of the most excellent book Active Value Investing, and one I recommend to anyone interested in value investing. Amazon.com)

Again, these are 10-year trailing P/E ratios. Notice how the P/Es always go back below the average? And we are a long way from the average now. There are two ways that we can get back to low P/Es. Either the stock market can go down or earnings can go up faster than prices (or some combination thereof). The stock market bottomed in 1974 in terms of price, but in terms of valuation the market took another eight years to get to its low. Then in 1982, with valuations below 10, the stock market was a coiled spring ready to explode.

Let's look at one more chart from Vitaliy. This chart shows the one-year trailing P/Es. Today, if you go to the S&P 500 tables at Standard and Poor's, you find the current P/E ratio is a heady 22, with the long-term one-year average being 15.2. There is a long way to go before we get to anything we can call mean reversion.

Hedging Your Bet

Now, let's look at how Warren's bet would have done in the bull market years of 1990-99. We will compare how a fund of hedge funds index from hedgefund.net did between 1990 and 1999, to the S&P 500.

(Note: these hedge fund indexes are representative of funds of funds in general, but you cannot invest in them. They have problems like survivor bias; they don't have all the fund of funds, just the ones that report, etc. Past performance is not indicative of future results. Further, the hedge fund climate is much different today than in 1990. But the indexes are the best proxy we can find if we want to do a comparison.)

The S&P 500 rather handily beat the hedge funds. The S&P 500 went from 353 to 1469 in those 10 years, for an average total return (including dividends) of 433%, or an average 18.2% a year. The hedge fund index returned 14% a year for a total return of 271%, net of fees. The standard deviation for the S&P 500 was 13.38% and for the hedge funds was a lower 7.87%, so the hedge funds were a lot less volatile. Still, buy-and-hold index investors were rewarded for the risk. The chart below shows how $1,000 invested might have grown over the 10 years.

Now, let's look at the last 10 years, from May 1998 to May 2008. Here we use a fund of funds index from Barclayhedge.com. Now, we find a different story. The market returned 4.21% on average, or a total of 51%, with a standard deviation of 14.7%. The hedge fund index returned 7.7%, with a standard deviation of 5.1%. So, you got a lot less return with a lot more volatility, if you stayed with the S&P 500.

Of course, there was a nasty bear market in 2000-2002, and a roaring bull market in the 1990s. But let me make one observation. In 1990 the P/E ratio was 15 and had been below 12 just a few quarters earlier. In 1998 the P/E ratio was 27.8, almost double what it was eight years earlier. A lot of the difference came from the starting point of stock market valuations.

Where are we today? The P/E ratio is 23.2. Earnings are dropping as we work our way through a very tough economy. As I have written elsewhere, I think the recovery, such as it is, will take at least two years before we can get back to 3% growth, because the twin bubbles of the housing market and the credit crisis will take at least two years to work themselves out. 1-2% growth in GDP for the next two years is not an environment for significant earnings growth. It is also not an environment in which stock markets are likely to thrive.

Roughly 20% of the S&P is financial stocks. Do you think they are likely as a group to start reporting robust earnings growth over the next two years? They are deleveraging, which will not help earnings growth. There are more write-offs to come. A significant portion of the S&P is tied to US consumers, who are pulling back. On the other hand, there are some very large multinational corporations that are benefitting from a weak dollar, as both their exports rise and their foreign subsidiaries profit.

But the climate is not favorable to robust earnings growth for the next few years. That will make it tougher for the stock market to keep up with the funds of hedge funds.

Mean Reversion of National Wealth

One more thought pointed out to me by Woody Brock: National wealth is a mean-reversion machine. That is a fundamental basic truth in economics. Over very long periods of time (multiple decades), growth in national wealth will equal growth in nominal GDP. And by national wealth, I am referring to our homes, stocks, bonds, real estate, etc.

Now, nominal GDP has been running about 5.5% for a long time. But between 1981 and 2006, US national wealth grew at an astounding 7.2%, from $10 trillion to $57 trillion. Mean reversion, or getting back to the average, means that national wealth must dip below 5.5% for an extended period of time. Woody thinks that from 2009 to the end of the next decade, we could see national wealth grow between 2.5-3%, well below our recent experience. National wealth is likely to fall this year and maybe next as housing values drop. This drop in wealth and slower growth means that consumers are not likely to return to their previous "shop till we drop" mode. And that is a serious pressure on earnings.

Graham taught us that in the short run the stock market is a voting machine, but in the long run it is a weighing machine. And what it weighs are earnings.

I have little doubt that earnings will rise at 6-8% on average over the next 10 years. The 1990s saw earnings more than double over 10 years, and the back of my napkin says that is around 8% annualized growth, although earnings dropped by 50% over the next three years. Over the very long run, earnings are going to grow at the level of nominal GDP, or around 5.5-6%.

For the stock market to do more than 6%, P/E levels would have to rise to even loftier levels than at present. Can it happen? Sure, it did in the late '90s; but we saw how that ended.

Let's go back to the graphs from Katsenelson. If P/E ratios continue the process of mean reversion and continue to fall, that will be a serious headwind for stock market growth. And we have no example in history where valuations did not revert to the mean. That doesn't mean that this time it couldn't be different. But that is not usually the way to bet.

If it was 1990 and a lower P/E, or 2002 and low P/Es (on a normalized basis), when the stock market outperformed the hedge funds, then I would not want to bet against Warren. But with today's valuations, a Muddle Through Economy staring us in the face for the next two years, a potential and serious tax increase in 2010 that would prolong any recovery and be even more problematical for earnings and stocks, I think the absolute-return funds will win this time.

In the end, it will depend on how good the funds of funds are that Protege picked, but these are savvy managers. They want to win, and I bet they picked the best they could find. We will find out each year at the annual Berkshire meeting how the bet is coming along. Right now, the market is down 10% and the hedge funds are down about 2%, but this is a long race. The first five months mean very little.

But the real winners will be the charities they have picked. And that is a good thing, not matter who wins the bet.

Now, if Buffett bet that Berkshire will do better than the funds of funds, I would not take that bet. But that is another story.

Fighting inflation or avoiding recession?

A first question: what’s the primary objective – inflation or growth? The American Federal Reserve has chosen growth. For fear of recession, it lowered the interest rate to 2% - two points below the rate of inflation. The gamble is that the cyclical slowdown will still put the brakes on price increases, despite the energy shock and agricultural prices, and even though inflation forecasts have reared their heads – above all (but not only) in the short term. Paul Volcker, the architect of disinflation in the 80s, has said that recent months remind him of the early 70s. Even then the oil shock was accompanied by a rise in agricultural prices, a weakening of the dollar, and an expansive monetary policy to counteract recession. The result was a decade of inflation.

The Bank of England made the opposite choice – it’s keeping interest rates at 5% (2 points above the inflation rate), because it wants inflation to fall towards the target of 2%, while recognising that the English economy risks winding up in recession, driven by tight credit, the drop in house prices, and the oil shock. The economic situation in England still isn’t as serious as that in America, yet the orientations of the two central banks are very different. Mervyn King, governor of the Bank of England, has emphasised that the Bank “did not fall prey to the sirens who were pressing us to cut interest rates as rapidly as some other central banks have done”.

The European Central Bank is going even further, surprising everyone with a warning that a hike in interest rates is imminent, despite the global slowdown and the ongoing credit crunch. This is remarkable, because the source of higher inflation is clearly exogenous to the Euro area and not due to domestic overheating or wage increases. By implication, the ECB welcomes a slowdown of the European economy to make sure that external inflationary pressures do not ignite a domestic wage-price spiral. The contrast with the Fed approach could not be more striking; one of the two central banks must be making a mistake.

Monetary policy indicators

A second question concerns monetary policy indicators. The monetarist doctrine suggested keeping an eye on monetary aggregates in order to prevent their excessive growth from overheating the economy. This vision was then substituted by a new orthodoxy – that the quantity of money has no stable relationship with economic activity, so central banks need to set interest rates with an eye on inflation forecasts and growth, ignoring what happens to the quantity of money. The financial crisis revalued old monetarist ideas – not in the sense of keeping the quantity of money under control, but rather of counteracting too rapid growth of credit aggregates. The credit crisis of recent months was fed by excessive growth of financial leverage – that is to say, credit. If the central banks had paid attention, we might not be in the mess that we are in today. The ECB has scored a point in its favour, here, as it has always said that it was paying attention to monetary aggregates. While economists have derided it in the past for being too faithful to monetarist hang-ups, it now appears that the ECB has been wiser than other central banks.

Bursting asset bubbles

This brings up the next question. What should monetary policy do about speculative bubbles in asset markets? The response of the central banks has always been to react to the macro effects of the bubble (on inflation and growth) without trying to burst the bubble pre-emptively. Critics say that’s too condescending an attitude. If you really think market prices are distorted by a bubble, why limit yourself to picking up the pieces? Wouldn’t it be better to act before disaster arrives and force the bubble to burst? Central bankers give two answers. First, it’s hard to identify bubbles and second, we don’t want to destabilise the aggregate economy just to make them go away. But the damage done by the bubble on the housing market is causing a rethink. Above all, the instruments available to monetary authorities aren’t only interest rates. Even the Federal Reserve now admits it should have fought speculation with stricter regulation.

Liquidity limits

A fourth problem is how far authorities should go in offering liquidity to the markets. Some central banks were initially too reluctant, precipitating the crisis. Now there’s the opposite fear – that central bank portfolios are chock full of assets of dubious quality. It’s difficult to find the right balance between sustaining liquidity and avoiding an indiscriminate rescue of those who erred at the expense of taxpayers.

Central bank autonomy

There’s also a political side to these questions. Delegating monetary policy to an independent bureaucracy requires that policy decisions be guided by technical criteria and a solid knowledge of the subject matter. If instead, larger and more uncertain questions open up, politicians will be tempted to break central bank independence and take back decision-making. Note what happened after Bear Stearns was rescued. Some Congressmen asked the Fed to give favourable treatment to student loans, allowing banks to go to the central bank and swap them for the safer T-Bills. And the Fed promptly obeyed. The next step, where the central bank will be asked to help companies or sectors close to the heart or pockets of politicians, is not far off.

Guido Tabellini is Professor of Economics at Bocconi University, co-author of "Political Economics: Explaining Economic Policy," and a CEPR Research Fellow.

It was then that the inflationary psychology -- which later led to so much grief -- took hold. Vietnam War spending and the Fed's easy-money policies created an economic hothouse. Government officials and most academic economists underestimated the danger. Inflation crept from negligible levels to 3.5 percent in 1966 and 6.2 percent in 1969. There are eerie parallels now. From 1997 to 2003, inflation averaged slightly more than 2 percent. Now it's 4 percent; some economists soon expect 5 percent. Hmm.

To be sure, differences abound. Then, we had a classic wage-price spiral. Strong consumer demand allowed businesses to raise prices, which spurred demands for higher wages that companies paid because they needed the workers and could recover the costs through higher prices. In 1959, labor costs rose 4 percent; firms could offset most of that through efficiencies (a.k.a. "productivity"). By 1968, labor costs were up a less-forgiving 8 percent.

By contrast, today there's not yet a wage-price spiral. Inflationary pressures seem to originate mostly in rising raw materials prices. In 2002, oil was $25 a barrel; now it's $135. Corn was $2.30 a bushel; now it exceeds $7. Copper was 70 cents a pound; now it's $3.80. Meanwhile, a powerful anti-inflationary force -- cheaper manufactured imports -- is waning. The weaker dollar and higher transportation costs have raised import prices. In the past year, prices for imported consumer goods (excluding autos) are up 3.6 percent.

We seem to be hostage to global forces. Economists Richard Berner and Joachim Fels of Morgan Stanley call this the "new inflation," because it's not easily squelched by domestic policies. Up to a point, that's true. Although the Fed influences interest rates, it doesn't own oil rigs or cornfields. Long-term price relief for oil involves switching to more-fuel-efficient vehicles and increasing worldwide, including American, oil production. Removing subsidies for corn-based ethanol would reduce food price pressures.

Still, all large inflations involve "too much money chasing too few goods," as economist Milton Friedman often noted, and this episode is no exception. The Fed's easy-money policies have global effects. Many countries peg their currencies to the dollar -- formally or informally -- and shadow Fed policies. Meanwhile, oil producers and other commodity exporters have been flooded with dollars; in practice, the extra cash allows them to run easy-money policies. The result is that despite the U.S. slowdown, much of the world is booming. Developing countries, now about half the global economy, have been growing at about 7 percent since 2002. Higher inflation is a worldwide phenomenon. In China and India, it's about 8 percent. In Russia, it's 15 percent.

One antidote to rising raw materials prices is for the Fed to reverse its easy-money policies. Combating inflation is rarely popular or easy, because it involves slowing the economy -- even inducing a recession -- to relieve pressures on prices and wages. Unemployment rises. There are usually plausible reasons for waiting. Surely there are now. Housing remains in disarray. More loan defaults could increase bank losses. No matter what the Fed does, there are dangers. Perhaps inflation will spontaneously subside (as some Fed officials hope) because the economy is already weak.

But similar arguments for delay were made in the 1960s, with disastrous results. The resulting inflationary psychology made inflation harder to extinguish. The initial unwillingness to take a modest slowdown or recession led to deeper subsequent recessions. There are now signs that we are at a similar juncture. Surveys show that people's "inflationary expectations," after years of stability, are rising. The Fed is holding its key interest rate at 2 percent, well below prevailing inflation. In the 1970s, this condition stoked inflation. An indecisive Fed risks repeating its previous blunder.

Indeed, thanks to weak-dollar driven price increases after the 1971 collapse of Bretton Woods, real GNP under Richard Nixon grew 8.8 percent in the first quarter of 1973. Not long after, Nixon was forced out of office. The weak dollar also led to impressive GDP growth during Jimmy Carter’s presidential term despite economic realities that suggested a very unhappy electorate when it came to the economy.

GDP growth was high under Presidents Reagan (32%) and Clinton (31%), and just the same it’s been mostly strong under President George W. Bush. Still, no one would mistake the booming Reagan (S&P 500 + 121%) and Clinton (S&P 500 + 208%) economies for the one we’ve experienced during Bush’s (S&P 500 +2%) tenure. GDP measures the total market value of all goods and services produced, and with the dollar impressively weak this decade, it’s unsurprising that this might show up in a positive way given the bogus nature of GDP calculations.

About GDP it should also be said that some of the inputs used to calculate the number misread economic strength. The alleged trade “deficit” is merely a signal that lots of capital is flowing our way from around the world, and while that’s an economic positive, a large deficit in this area subtracts from GDP growth. Conversely, government spending is by definition an economic retardant for capital being removed from the private sector for immediate government consumption, but when it comes to GDP, this adds to economic growth. The silly “stimulus” packages from 2001 and this past spring that “increased” GDP should be considered in this light.

19th century political economist Alfred Marshall defined labor as “any exertion of mind or body undergone partly or wholly with a view to some good other than the pleasure derived directly from the work.” Marshall’s definition of labor defines that which is economic growth, so recession or no recession, there seems to be a general consensus (confirmed by a very unhappy electorate) that something’s wrong such that Americans aren’t putting forth work effort in ways they once did. So rather than debate unreliable data points, it should be asked why people are working less.

On the tax front, the 2003 tax cuts reduced the penalties on work and investment. The reductions were a positive, but with the White House set to change hands in November, there’s a great deal of uncertainty about what’s ahead. On the one hand Barack Obama would like to sunset those cuts, and on the other John McCain at least publicly supports the very decreases he voted against five years ago. Those who like low tax rates have reason to be scared either way.

Removal of the above uncertainty one way or the other would be a big positive in that workers and investors would know with certainty what the future tax picture will look like. A fluid tax environment creates a fluid and economy-retarding work environment. It says here that the GOP is correct in its push to make the ’03 tax legislation permanent.

Still, the U.S. economy since World War II has performed well under all manner of tax regimes. While low penalties on work and investment offer the ideal growth environment, the economy has performed better in decades past despite higher income and capital gains rates. And when we consider the 2003 cuts, they were easily marginalized by a collapsing dollar which is itself a huge tax on income and investment. As right as the GOP presently is on taxes, the dollar’s collapse on its watch has in many ways discredited any gains made by tax-rate reductions. It is said that “politicians don’t do currencies,” and the GOP’s unwillingness to “do currencies” has and will be a path to minority status in both houses of Congress alongside a President Obama.

And while it’s hard to gauge its impact on work effort, last week’s photos of former Bear Stearns fund managers Ralph Cioffi and Matthew Tannin being hauled off in handcuffs were a sick reminder that failure in the United States is increasingly against the law. The Cioffi/Tannin case is a federal one, and it goes hand-in-hand with the Department of Justice’s past destruction of Arthur Anderson which occurred in concert with Congress's passage of the risk-reducing Sarbanes-Oxley. Innovation by definition frequently occurs alongside failure, and with commercial mistakes increasingly the path to jail, it’s fair to ask how much the “tough” stances taken by federal officials when it comes executive mistakes have played a part in what the electorate deems a difficult economic landscape.

Returning to the recession debate, it’s hard to defend Democratic partisans who, with the November elections in mind, seem to delight in the pain wrought by economic uncertainty. When we consider a Democratic platform that consists of increased tax rates, harsh measures against oil companies and more regulation, the Party ought to be careful what it wishes for when it comes to future economic performance on its watch.

On the other hand, GOP partisans ought to be careful defending admittedly bogus GDP numbers that they would eagerly tear into were President Bush a Democrat. Indeed, heading into the 1996 elections it was said by those partial to the GOP that the 2.6 percent GDP growth President Clinton presided over was weak relative to that experienced under Ronald Reagan. While positions taken over 10 years ago were perhaps well founded, 2.6 percent would be a great number today. More realistically it should be said that the IPO market’s disappearance in tandem with a collapsing dollar and a 2 percent rise of the S&P on Bush’s watch is not an economy to defend or write home about.

The numbers used to calculate “recession” or “growth” really only matter insofar as a positive number might save us from another economy-retarding “stimulus” package that would “increase” GDP all the while harming our real economic prospects. Sadly, neither party is talking about the dollar, and with the latter the most problematic economic variable by far, it should be said that whichever party wins in November can expect a short economic honeymoon so long as the greenback is ignored.

Two goals but only one instrument

One of the major problems of central banking is that the pursuit of these two core purposes can often conflict, not least because the central bank currently appears to have only one instrument, its command over the short-term interest rate. Indeed, a central purpose of the first two great books on central banking, Henry Thornton’s (1802), Inquiry into the Paper Credit of Great Britain, and Walter Bagehot’s (1878), Lombard Street, was to outline ways to resolve such a conflict, especially when an (external) drain of currency threatened maintenance of the gold standard at the same time as an internal drain led to a liquidity panic and contagious bank failures.

Under such circumstances, however, with rising risk aversion, the central bank would find that it had two instruments, due to its ability to expand its own balance sheet, e.g. by last-resort lending, at the same time as keeping interest rates high, (to deter gold outflows and unnecessary (speculative) borrowing). The greater problem, then and now, was how to avoid excessive commercial bank expansion during good times. With widespread confidence, the commercial banks neither want nor need to borrow from the central bank. A potential restraint is via shrinking the central bank’s own balance sheet, open market sales, thereby raising interest rates. But increasing interest rates during good times, (gold reserves rising and high; inflation targets met), i.e. ‘leaning into the wind’, is then against the ‘rules of the game’, and such interest rates adjustments small enough to be consistent with such underlying rules are unlikely to have much effect in dampening down the upswing of a powerful asset price boom-and-bust cycle.

CP1: ‘Price stability’ versus CP2: ‘Financial stability’

Although the terminology has altered, this basic problem has not really changed since the start of central banking in the 19th century. An additional analytical twist was given by Hy Minsky, who realised that the better the central bank succeeded with CP1 (price stability), the more it was likely to imperil CP2 (financial stability). The reason is that the greater stability engendered by a successful CP1 record is likely to reduce risk premia, and thereby asset price volatility, and so support additional leverage and asset price expansion. The three main examples of financial instability that have occurred in industrialised countries in the last century (USA 1929-33, Japan 1999-2005, sub-prime 2007/8) have all taken place following periods of stellar CP1 performance.

We still have not resolved this conundrum. It shows up in several guises. For example, there is a tension between trying to get banks to behave cautiously and conservatively in the upswing of a financial cycle, and being prepared as a central bank to lend against whatever the banks have to offer as collateral during a crisis. Again, the more that a central bank manages to constrain bank expansion during euphoric upswings, e.g. by various forms of capital and liquidity requirements, the greater the disintermediation to less controlled channels. How far does such disintermediation matter, and what parts of the financial system should a central bank be trying to protect? In other words, which intermediaries are ‘systemic’; do we have any clear, ex ante, definition of ‘systemic’, or do we decide, ex post, on a case-by-case basis?

Bank risk and bank-system risk

Perhaps these problems are insoluble; certainly they have not been solved. Indeed, recent developments, notably the adoption of a more risk-sensitive Basel II CAR and the move towards ‘fair value’ or ‘mark-to-market’ accounting, have arguably tilted the regulatory system towards even greater pro-cyclicality. A possible reason for this could be that the regulators have focussed unduly on trying to enhance the risk management of the individual bank and insufficiently on the risk management of the financial system as a whole. The two issues, individual and systemic risk performance, are sometimes consistent, but often not so. For example, following some financial crisis, the safest line for an individual bank will be to cut lending and to hoard liquidity, but if all banks try to do so, especially simultaneously, the result could be devastating.

The bottom line is that central banks have failed to make much, if any, progress with CP2, just at the time when their success with CP1 has been lauded. This is witnessed not only by the events of 2007/8, but also by the whole string of financial crises (a sequence of ‘turmoils’) in recent decades. Now, there are even suggestions that central banks should have greater (even statutory) responsibility for achieving financial stability, (e.g. the Paulson report). But where are the (regulatory) instruments that would enable central banks to constrain excess leverage and ‘irrational euphoria’ in the upswing? Public warnings, e.g. in Financial Stability Reviews, are feeble, bendy reeds. All that central banks have to offer are mechanisms for picking up the pieces after the crash, and the more comprehensively they do so (the Greenspan/Bernanke put), the more the commercial banks will enthusiastically join in the next upswing.

Counter-cyclical instruments

Besides such public warnings, which the industry typically notices and then ignores, the only counter-cyclical instruments recently employed have been the Spanish pre-provisioning measures, and the use of time-varying loan to value (LTV) ratios in a few small countries, e.g. Estonia and Hong Kong. But the Spanish measures have subsequently been prevented by the latest accounting requirements, the IFRS of the IASB; and the recent fluctuations in actual LTVs have been strongly pro-cyclical, with 100+ LTVs in the housing bubble being rapidly withdrawn in the housing bust.

Indeed, any attempt to introduce counter-cyclical variations in LTVs or in capital/liquidity requirements will always run into a number of generic criticisms:

• It will disturb the level playing field, and thereby cause disintermediation to less regulated entities (in other segments of the industry, or in other countries). It will thus both be unfair and ineffective.
  
• It will increase the cost of intermediation during the boom and thereby reduce desirable economic expansion (and financial innovation).
  
• It will increase complexity and add to the informational burden.
  

But those same generic criticisms will also mean that regulators/supervisors will be roundly condemned for tightening regulatory conditions in asset prime booms by the combined forces of lenders, borrowers and politicians, the latter tending to regard cyclical bubbles as beneficent trend improvements due to their own improved policies. Regulators/supervisors will need some combination of courage, reliance on quantitative triggers, and independence from government if they are to have the strength of mind and purpose to use potential macro-prudential instruments to dampen financial booms.

Charles A.E. Goodhart is the Norman Sosnow Professor of Banking and Finance at the London School of Economics.

The Kelo decision was enormously unpopular, with polls showing that between 80 percent and 90 percent of Americans disagree with the idea, even when property owners received market value for their land. Still, that hasn’t stopped the politicians and urban planners, who moved in quickly. In the first year after Kelo, according to a study by the Castle Coalition, which tracks eminent domain seizures, state and local governments condemned or threatened to condemn more than 5,400 properties, compared to slightly more than 10,000 such actions in the previous five years. In the eminent domain business, a threat to condemn is usually just as good as an actual taking, since a homeowner can’t sell a house under those conditions and a business would find it difficult to do things like get credit.

The homes and businesses targeted in the wake of Kelo ranged from a seafood restaurant in Freeport, Tx., whose property officials wanted so that they could expand a local marina, to a parking lot in Oakland, Ca., which the city wanted to take from a private owner and hand to an auto parts store, to single family waterfront homes in Long Branch, N.J., that the city wanted to see redeveloped into luxury condominiums.

Most Americans object to such takings because the intended uses of the land don’t justify violating property rights when the owner is unwilling to sell to government. But as Jacobs observed, another important objection is that government planners often do a lousy job of anticipating the marketplace when they take property to be developed into something new. What I call mega-project ‘state capitalism,’ the grandiose schemes of politicians and their planners to invest public money in big projects like stadiums, downtown super-malls, and subsidized entertainment districts, has been on the rise for years, often with disastrous results which should have given the Supreme Court justices pause before they gave their blessings to seizures that "provide appreciable benefits to the community."

Indeed, the very redevelopment project that sparked the Kelo lawsuit, an effort by the town of New London, Ct., to turn its Fort Trumbull waterfront into a haven for high-priced homes and 21st century jobs, has sputtered. The ground where Susette Kelo’s home stood is now barren, because the townhouses that the city-sponsored developer was supposed to build there have never gone up. Interest in the area isn’t very great and the developer hasn’t been able to get financing. In fact, what began more than a decade ago as an extravagant ‘public-private’ scheme to redevelop this whole area around tourism, research and development and luxury residential uses has produced little except ongoing construction on a $17 million Coast Guard station.

State capitalism provides more examples of losers than winners. Consider the convention center business. About 25 years ago urban politicians noticed that a few cities, notably Chicago, Las Vegas and Orlando, were cashing in on a booming convention and business meetings marketplace. Almost in tandem around the country, cities rushed to build convention centers or expand their current ones, investing billions in tax subsidized dollars. In some cases, such as facilities in Boston and San Francisco, officials also used eminent domain to take control of private property that stood in the way of the building of their new centers.

The result has been a disaster for the taxpayer. Dozens of new convention properties have opened around the country, creating a glut of convention space, and most centers are underperforming. In 1986 the country boasted 194 centers sporting about 32 million square feet of space, while today there are 322 featuring 66.8 million square feet, with about 40 million more square feet under construction, according to congressional testimony by Professor Heywood Sanders of the University of Texas. The building boom, coming at a time when the convention business has been flat, has turned many of these projects into money-losers. Projections that the new centers would create thousands of jobs to boost the local economy have rarely materialized, leaving taxpayers in Boston, Baltimore, St. Louis and Washington, D.C., among other places, on the hook for additional subsidies.

Public officials and planners continue to pursue such projects in the face of repeated failures in part because redevelopment schemes and ‘public-private partnerships’ help put enormous additional power in the hands of politicians and the private entrepreneurs who partner with them.. In California, for instance, 390 redevelopment agencies operate with the power to condemn property, tax and float debt. Collectively these redevelopment agencies, many run by municipalities and controlled by local politicians, own some $13 billion in property, generate nearly $9 billion a year in revenues (mostly from dedicated taxes) and have racked up some $81 billion in debt—most of it paying tax-free interest thanks to the federal tax code.

Redevelopment authorities and public-private partnerships are especially common in places like California where government has created such a hostile environment for business that officials justify their work as necessary to jumpstart a sluggish economy. But as Doug Kaplan, a California developer, has observed in a piece he wrote for the Castle Coalition, local government would serve their communities better by simply cutting red tape for new development, reducing fees, and focusing on basic government services like public safety, while leaving the rest to the market. Asked by a local redevelopment officer to join a ‘public-private partnership” to open a restaurant in a depressed downtown, Kaplan told him,” If you really want to revitalize downtown, then light the sidewalks, fix the roads, take care of the police, support the schools.” That’s not a message most redevelopment types, or politicians, want to hear, however.

In the wake of public reaction against Kelo, officials in many states promised they would seek laws limiting local use of eminent domain, but although a few states have put in tougher restrictions, in many places there has been little reform because regardless of public sentiment, officials like the power of takings that the Supreme Court gave them. The League of California Cities and the California Redevelopment Association, for instance, undermined efforts by taxpayer groups to pass a referendum restricting eminent domain by putting their own competing, but much weaker referendum on the ballot, one which doesn’t prohibit condemnations against businesses, who are the most common target of seizures.

Today, three years after Kelo, the game of public sponsored economic development subsidized by taxes, tax-free bonds, tax-breaks for favored businesses, and the threat of eminent domain, is alive and well, supporting everything from mega-projects like the massive 22-acre Atlantic Yards in Brooklyn, N.Y., to the efforts by the tiny California town of Hercules to take land away from Wal-Mart because the town fathers objected to the big box retailer invading their domain. Kelo has allowed local officials throughout the country to remain masters of eminent domain, and private markets continue to suffer as a result.

Besides the laughter you hear from the European Central Bank, the major sound that one hears in the aftermath of all of this is the silent residue of shame at the Fed. To be blunt, the inability to craft and communicate an effective message to convince both the market and public of its intent to deal with the sharp increase in the cost of living has damaged the credibility of the central bank. This utterly avoidable episode begs the question: Is the Fed in the process of losing control of both the market and inflation expectations simultaneously?

It is clear that the Fed did not thoroughly think through the reaction of the market to a sudden and inchoate turn in rhetoric. The embarrassing debasement of its own statements after only a few days did not add one ounce of stability to the markets, did little to regain control of long term rates, and failed to put a real floor under the dollar.

Worse (yes, it gets worse), public expectations of future inflation are in the process of becoming unmoored. The University of Michigan’s survey of consumer confidence has seen its one and five year estimates of inflation expectations increase to 5.1% and 3.4% respectively. Inside the Conference Board’s estimate of consumer sentiment, the public now expects that inflation over the next year will increase by 7.7%. Both surveys provide little relief to a beleaguered Fed.

A look at Fed funds futures suggests that the FOMC will remain on hold until September when traders think that there is a 58.5% chance of a 25 basis point hike. Conversely, the options market remains uncertain about the Fed's next move. The difference in expectations caused by the ineffective and ill-conceived statements out of the Fed can be expected to continue until the FOMC begins to craft an effective communication policy that lays out the rationale for its future conduct of monetary policy. With economic growth in the middle of the year looking much more uncertain than it did when Fed adopted a hawkish tone, the case for a fall hike is becoming more diminished by the day, and with it Fed credibility.

Although the disenchantment of investors with Fed is quite clear, the central bank is not without its supporters. Defenders of the Fed would make the case that the central bank has quite a bit of latitude to wait on inflation to subside. Given the slowdown in economic activity, resource utilization and emerging slack in the economy should provide the sufficient relief to inflation the Fed has been looking for later this year. Most importantly, the Fed still does not believe that inflation expectations are very great.

Indeed, what many consider to be the Fed’s preferred indicator of medium term inflation expectations, the five-year forward, has yet to indicate a crisis. This measure, which attempts to strip out near-term pricing disturbances caused by volatile measures such as energy and food prices, gives the Fed a window into what the market anticipates inflation to be five years hence. This important indicator has yet to push back above 3.0% in 2008 after doing just that at the end of 2007.

Perhaps, but waiting on the economy to illustrate sufficient slack, and for the market to catch up with the inflation expectations of the public at a time of major structural change in demand for commodities and energy at the global level suggests a Fed that is intellectually exhausted.

One only need look at the current pricing environment to ascertain the level of risk entailed by current monetary policy. I expect the consumer price index to breach 5.0% in the upcoming June reading. The Fed’s own preferred measure of inflation, the core PCE deflator, should advance to 2.3%; well above the Fed’s implied target range. And, all things being equal, the PCE core rate one year out should be near 2.7%.

Making matters that much more interesting is that core and headline intermediate costs, as suggested by the recent producer price index, are showing signs of reaching a boiling point. On a three-month annualized average total intermediates are up 27.7% through May. Stripping out volatile factors such as food and energy, they are up 18.5% over that same interval. Thus my own forecast may be underestimating what may actually occur. It is now not a matter of if, but when evidence of higher core rates begins to systematically show up in the data.

Firms are close to reaching a tipping point with respect to the costs of production. At some point corporate and small firms will blink and begin to pass through price increases downstream to customers. When that occurs, indicators such as the five-year forward will move strongly past 3.0% and the Fed may be forced to act well before it is actually are prepared.

Moreover, Mr. Bernanke, whose academic reputation rests on the efficacy of a workable inflation-targeting regime, might find it quite difficult to hold off on increasing rates once a preferred indicator breaches a critical threshold. At that point the Fed Chair would face the difficult choice of sacrificing his credibility. That, or move prematurely to hike rates that could send the economy into a much deeper tailspin than the fundamental data currently suggests is probable. Such are the stakes once inflation expectations begin to careen out of control

Losing control of inflation expectations is a fairly solid working definition of the term “loss of monetary credibility.” A majority of countries that employ the inflation targets that Mr. Bernanke champions now have rates of pricing that exceed their formal targets. Unlike Bank of England President Mervyn King, Mr. Bernanke will be spared the ignominy of an explanatory letter of failure to Parliament. But, if the Fed does not regain control of expectations soon, its credibility will be washed away in a sea of rising prices. If so, it will be years before the market or the public once again trust the Fed.

The reason is that while Nike is an American firm, its brand is international. If it happened to be that Castro preferred Nike track suits, he could simply have had one purchased in one of the many countries in which Nike sells its goods, and which have more open trading relations with Cuba.

We can and do export to Cubans through our commercial dealings with other countries. Just the same, as any smoker knows, our embargo on Cuba has not kept some of the world’s best cigars from the hands of Americans. To stop trade with Cuba would require a blockade to cut Cuba off completely from the outside world.

Both John McCain and Barack Obama have said they’ll maintain the five decade long embargo on Cuba. While this writer says they’re incorrect, all the talk about the Cuban embargo misses the point. Even if we lifted it, the problem remains that so long as economically unfree Cubans have very little to give us in return for our goods, there won’t be much wealth-enhancing trade between the countries.

Sadly, the false view suggesting that embargos are effective has been used as an excuse for centuries by countries to craft foreign policy alliances. Today they subsidize domestic goods in case those alliances break down, or to block corporate takeovers. The silliest policy of all is to impose embargos in the first place. So long as anyone in the world economy wants to buy, there will be a seller.

In the 18th century, the British government sought to build up reserves of gold because its fungible nature made it tradable for all manner of world goods. It was said that England must maintain good relations with Portugal to insure a reliable supply of the yellow metal. But as Adam Smith wrote in the Wealth of Nations, “Gold, like every other commodity, is always somewhere or another to be got for its value by those who have that value to give for it.” Even if Portugal had imposed an embargo on England, its gold “would still be sent abroad, and though not carried away by Great Britain, would be carried away by some other nation, which would be glad to sell it again for its price.”

Future events proved the wisdom of Smith’s words. National security issues were raised during England’s Corn Law debates in the 19th century. At that time the debate was about food. The theory among those who supported farm subsidies and tariffs was that if England’s agricultural interests were undercut by free trade, there would not be food to supply the troops or England’s citizens in times of war. Those who defended the Corn Laws forgot that England had been at war in 1810 with nearly every European power, yet still managed to import 1,491,000 quarters of wheat from those same European powers.

In the late 1970s, the United States imposed a grain embargo on the Soviet Union to punish its invasion of Afghanistan. Whether or not this was a good political move, thanks to more open trading relations between the Soviet Union and some of our non-embargoed trading partners, Soviet silos were still filled with U.S. produced grain.

More recently, the U.S. political class blocked a bid by the China National Offshore Oil Corporation (CNOOC) for California-based oil company Unocal. At the time, Reps. Duncan Hunter, Richard Pombo, and forty other congressmen sent the Treasury Department a letter asking for the deal to be reviewed for security concerns, while former CIA director James Woolsey told Forbes that the bid “is a conscious long-term effort to take over... as much of the American economy as possible.” Woolsey’s fear suggesting that Chinese oil demand would detract from our own economic interests gained political traction despite all the history showing its absurdity.

Indeed, whether or not CNOOC owned Unocal was and is largely irrelevant. The Chinese, like us and everyone else, demand oil from what is a world supply. The real reason CNOOC wanted to acquire Unocal was that many of its holdings were near China. Ironically enough, in a recent speech at the Gilder/Forbes Telecosm conference, economist John Rutledge noted that once Chevron’s acquisition of Unocal became official, its own representatives were in China negotiating the local sale of oil pumped from what were formerly Unocal wells!

In modern times, no commodity has been more misunderstood from the trade/embargo perspective than oil. Going back to FDR, every U.S. president has sought alliance with oil-rich Middle Eastern countries based on the discredited fear that, absent good relations, the oil will stop flowing our way.

What’s missed here is that oil is only wealth once it’s sold. Aside from the fact that most U.S. oil imports arrive from Canada, we’ll be the certain recipients of Middle Eastern oil even if every country in that region chooses to place an embargo on us. Once again, no-one controls the ultimate direction of any good once it's been sold.

The above naturally flies in the face of the ever popular and bi-partisan notion of “energy independence.” The latter term is an offshoot of the embargo myth, and is rooted in the false belief that absent an “American” oil supply, we could potentially be cut off from the world’s supply of oil. That this is logically impossible has not kept presidents going back to Richard Nixon from pursuing this false goal.

Whether increased domestic drilling is a good or bad idea, the idea of energy independence is a mirage. Indeed, even if U.S. wells produced every barrel of our domestic needs, our supply and demand would still combine with world supply and demand on the way to a world price. Just as oil producers that don’t like us can’t keep their oil from reaching our shores, neither can we embargo their access to our products in what is a world market. Suffice it to say, given the drastic impact of the dollar’s diminishing value on the price of oil, it seems a bit of a reach to assume that domestic discoveries whatever their size would reduce in any substantial way the price of a barrel.

There’s no accounting for the final destination of goods. Embargos don’t work, but they do make world trade more costly. Nations need to remove the barriers that retard the inevitable process whereby individuals exchange what they deem surplus for the surplus of others.

If you seek his monument, come to Silicon Valley, an incubator of the semiconductor industry. If you seek (redundant) evidence of the federal government's refusal to do the creative minimum -- to get out of the way of wealth creation -- come here and hear the talk about the perverse national policy of expelling talented people.

Modernity means the multiplication of dependencies on things utterly mysterious to those who are dependent -- things such as semiconductors, which control the functioning of almost everything from cellphones to computers to cars. "The semiconductor," says a wit who manufactures them, "is the OPEC of functionality, except it has no cartel power." Semiconductors are, like oil, indispensable to the functioning of many things that are indispensable. Regarding oil imports, Americans agonize about a dependence they cannot immediately reduce. Yet their nation's policy is the compulsory expulsion or exclusion of talents crucial to the creativity of the semiconductor industry that powers the thriving portion of our bifurcated economy. While much of the economy sputters, exports are surging, and the semiconductor industry is America's second-largest exporter, close behind the auto industry in total exports and the civilian aircraft industry in net exports.

The semiconductor industry's problem is entangled with a subject about which the loquacious presidential candidates are reluctant to talk -- immigration, specifically that of highly educated people. Concerning whom, U.S. policy should be: A nation cannot have too many such people, so send us your PhDs yearning to be free.

Instead, U.S. policy is: As soon as U.S. institutions of higher education have awarded you a PhD, equipping you to add vast value to the economy, get out. Go home. Or to Europe, which is responding to America's folly with "blue cards" to expedite acceptance of the immigrants America is spurning.

Two-thirds of doctoral candidates in science and engineering in U.S. universities are foreign-born. But only 140,000 employment-based green cards are available annually, and 1 million educated professionals are waiting -- often five or more years -- for cards. Congress could quickly add a zero to the number available, thereby boosting the U.S. economy and complicating matters for America's competitors.

Suppose a foreign government had a policy of sending workers to America to be trained in a sophisticated and highly remunerative skill at American taxpayers' expense, and then forced these workers to go home and compete against American companies. That is what we are doing because we are too generic in defining the immigrant pool.

Barack Obama and other Democrats are theatrically indignant about U.S. companies that locate operations outside the country. But one reason Microsoft opened a software development center in Vancouver is that Canadian immigration laws allow Microsoft to recruit skilled people it could not retain under U.S. immigration restrictions. Mr. Change We Can Believe In is not advocating the simple change -- that added zero -- and neither is Mr. Straight Talk.

John McCain's campaign Web site has a spare statement on "immigration reform" that says nothing about increasing America's intake of highly educated immigrants. Obama's site says only: "Where we can bring in more foreign-born workers with the skills our economy needs, we should." "Where we can"? We can now.

Solutions to some problems are complex; removing barriers to educated immigrants is not. It is, however, politically difficult, partly because this reform is being held hostage by factions -- principally the Congressional Hispanic Caucus -- insisting on "comprehensive" immigration reform that satisfies their demands. Unfortunately, on this issue no one is advocating change we can believe in, so America continues to risk losing the value added by foreign-born Jack Kilbys.

georgewill@washpost.com

Since the mid-1990s, there has been a trend towards greater transparency in economic policymaking – particularly with respect to monetary policy – and a number of central banks, including Sweden’s Riksbank and Britain’s Bank of England, have adopted a very transparent monetary policy regime known as inflation targeting. The United States does not subscribe to inflation targeting, but the Fed has also become much more transparent about its policymaking and operations over the past 15 years.

Economists have argued that greater transparency is beneficial, improving democratic accountability by making it easier to judge whether a central bank is committed to its announced policy and improving policy effectiveness by facilitating the interpretation of policy changes (see the very accessible review of the discussion by Posen 2002).

But greater transparency of central bank policymaking – in which committee deliberations are made more open to the public – may prevent the full and frank discussion needed to make the best decisions. In a recent paper (Meade and Stasavage 2008), we compare discussions of the Fed’s Federal Open Market Committee (FOMC) before and after committee members knew that all statements would eventually be made public. Our empirical results indicate that after 1993, when FOMC participants knew that their deliberations would be made public, they were less likely to challenge then Fed chairman Alan Greenspan. This suggests that greater transparency hindered free deliberation and may have permitted Greenspan's views on interest rates to dominate US policymaking. In the discussion of the current crisis in credit markets, some have suggested that US interest rates were too low for too long.

Closed doors and open minds

Concern about the effects of open deliberations is not new. Speaking about the secrecy rule that prevailed during the US Constitutional Convention of 1787, James Madison emphasized that full publicity would have made members more reluctant to express their true opinions freely. Madison saw secrecy as having been critical to the Convention’s ultimate success.

Fed policymakers expressed similar concerns when, in 1993, the US Congress pressured them to become more open about their decision-making process. At issue was whether the Fed would agree to publish verbatim transcripts from meetings of its Federal Open Market Committee (FOMC). In Congressional testimony, Alan Greenspan argued against publication, saying that the FOMC “could not function effectively if participants had to be concerned that their half-thought-through, but nonetheless potentially valuable, notions would soon be made public” even with a publication lag of five years. Greenspan noted further that the character of the meetings would change with transcript publication, from lively, useful sessions to bland, sterile ones. In the end, the Fed made the change and subsequently decided to make all of its meeting transcripts available. Transcripts of all FOMC meetings and conference calls from 1978 through 2002 are currently available on the Fed’s web site.

In our paper, we look at whether more information provided by the central bank to the public about monetary policy deliberations can affect the deliberation process itself and ultimately stifle useful debate. We employ a theoretical model in which policymakers care both about making the right policy decision and about how they are viewed by the public. We show that it is possible that policymakers could hold back during deliberations for fear of looking uninformed or incompetent if they know that the content of their discussions will eventually be released to the public. If this happens, then monetary policy might be adversely affected. Thus, the benefits of increased transparency would need to be assessed against the resultant damage to the policy process.

Unique aspect of FOMC transcripts: the tapes that weren’t destroyed

Our research employs a unique aspect of the situation and the transcripts themselves to analyse whether the publication of meeting records has affected the Fed’s deliberations. FOMC meetings have been recorded for more than 30 years so that the Fed staff can write meeting minutes after every meeting. (An account of each FOMC meeting has been published in some form following each meeting since 1936, but these published accounts have been short, non-attributed records of meeting discussion.) Policymakers knew about the recording but thought the tapes were destroyed after the minutes were written. Thus, transcripts exist from a time when policymakers did not know that their deliberations would be made public. We compare deliberations before 1993, when Fed officials believed their remarks were private, with deliberations after 1993, when officials knew that all statements would eventually be made public.

In our empirical analysis, we use a dataset collected from the transcripts themselves that codes verbal messages of each meeting participant and characteristics of the participants, including their name, Fed district, years of experience, and whether they are an official voter at the meeting and, if so, whether the official vote cast agreed with the verbal message sent during discussion. (In the Fed system, votes rotate in a fixed fashion for some policymakers, so that only 12 of the 19 officials vote at any given meeting).

Over the time period that we examine (1989-1997), Chairman Greenspan presented his proposal for the setting of the policy interest rate first and then solicited other meeting participants for their views. After all the participants had expressed their opinions, an official vote was taken on the policy proposal. We focus our analysis on the willingness of the meeting participants to express verbal disagreement with Greenspan’s proposed policy before and after 1993.

The empirical results provide clear evidence of a change in the character of FOMC deliberations – policymakers were less likely to express verbal disagreement with Greenspan’s proposal after 1993. This remains the case even after other potential influences on officials’ views, such as a variety of measures of the current economic environment as well as Fed forecasts for inflation, are taken into account.

We tested the robustness of these empirical results using supplementary hypotheses. First, while the publication of transcripts may have affected FOMC deliberations, it should have had no impact on the votes of policymakers because the votes were published both before and after 1993. We tested the votes in our empirical model and found that votes were unaffected by the release of the transcripts. Moreover, a policymaker should have been less likely to switch his view on the policy proposal between the discussion and the vote – for example, verbally disagreeing with the proposal but voting in favour of it – once the transcripts became public. Our empirical results also accord with this.

Conclusions

Our empirical findings are supported by a number of parallel observations about the changing character of FOMC debate since 1993. While before 1993, FOMC discussions were characterised by frequent “off the cuff” remarks and interruptions, since 1993 there has been an increase in prepared statements that may result in less real deliberation. Our results have significant implications for the design of monetary policy institutions, as well as for the operation of committee-based government decision-making more generally.

References

Meade, Ellen E. and David Stasavage (2008). “The Dangers of Increased Transparency in Monetary Policymaking,” Economic Journal April, 695-717.

Posen (2002). “Six Practical Views of Central Bank Transparency”, http://www.iie.com/publications/papers/posen0502.pdf

Authors

Ellen E. Meade is Associate Professor in the Department of Economics at American University. David Stasavage is Associate Professor of Politics at New York University.

These market warnings are two sides of the same coin. Inflation, which is caused by excess dollar creation, is the cruelest tax of all. It is a tax on consumer and family purchasing power. It is a tax on corporate profits. It is a tax on the value of stocks, homes, and other assets.

Crucially, the capital-gains tax — the most important levy on all wealth-creating assets — is un-indexed for inflation. Hence, long before Barack Obama or Congress can legislatively raise the capital-gains tax rate, rising inflation is increasing the effective tax rate on real capital gains. That's an economy-wide problem.

By doing nothing at the June 25 meeting the Fed turned its back on the very inflation-tax problem it helped create. The spanking it received from the markets was well deserved.

Former chairman of the Fed, Paul Volcker, who is advising Senator Obama's presidential campaign, issued a stern warning at the New York Economics Club a few months back. He said inflation is real and the dollar is in crisis. Soon after, Fed head Ben Bernanke changed his tune in public speeches, pledging greater vigilance on inflation and hinting at a defense of the dollar. Treasury man Henry Paulson and President Bush also stepped up their rhetoric regarding a stronger greenback.

But words were no substitute for actions this week.

It is an interesting historical footnote that Paul Volcker still is highly regarded as the greatest inflation fighter of our time. Working with Ronald Reagan, it was Mr. Volcker who slew the inflation dragon in the 1980s. Indeed, the combination of tighter monetary control from the Fed and abundant new tax incentives from Reagan launched an unprecedented 25 year prosperity boom characterized by strong growth and rock-bottom inflation. At the center of the boom was a remarkable 12-fold rise in stock market values, a symbol of the renaissance of American capitalism. But that was then and this is now.

Talk of major new tax hikes is in the air today, while the inflationary decline of the American dollar is plain fact. It's as though our economic memory is being erased, both in tax and monetary terms. Staunchly optimistic supply-siders Arthur Laffer and Steve Moore are even finishing a book on the subject. Called "The Gathering Economic Storm," its concluding chapter is titled: "The Death of Economic Sanity."

The Volcker anti-inflation model presumably handed down to Alan Greenspan and Ben Bernanke always argued that price stability is the cornerstone of economic growth. Yet it appears that today's Fed has reverted to a 1970s-style Phillips-curve mentality that argues for a trade-off between unemployment and inflation, rather than the primacy of price stability.

History teaches us otherwise. It states that since rising inflation corrodes economic growth, inflation and unemployment move together — not inversely. Even in the last 18 months this is proving true. Inflation bottomed around 1% in late 2006. Unemployment bottomed at 4.4% about 6 months later. Today, the CPI inflation rate has climbed to more than 4%, wholesale prices have jumped to 7%, and import prices have spiked to 18%. Unemployment, meanwhile, has moved up to 5.5%.

Over the past five years the greenback has lost 40% of its value. Oil is close to $140 a barrel. And gold, now trading above $900 an ounce, is warning that if the Fed fails to stop creating excess dollars, inflation could rise to 6% or 7%. I had hoped Mr. Bernanke would show his inner Volcker at Wednesday's meeting. He didn't. While the Fed acknowledged that "the upside risks to inflation and inflation expectations have increased," it took no action taken to raise the fed funds target rate, which now stands at 2% and is actually minus-2% adjusted for inflation. Even a quarter-point rate hike — merely taking back the last easing move in April — would have been a shot heard 'round the world in defense of the beleaguered dollar. It didn't happen.

Only Richard Fisher, president of the regional Dallas Fed, dissented in favor of a higher target rate. That leaves the hard-money Fisher as the lone remaining protégé of Paul Volcker.

Of course, if Fed policymakers reconvene immediately to right their wrongheaded mistake, the value of our money could be quickly restored. The next scheduled Open Market meeting is August 5, but they needn't wait that long.

Let's hope they come to their senses.

Today the worry on the mind of investors and central bankers is inflation. It is causing havoc with the markets. In this week's letter, we look at whether we should be worried about inflation, take a mid-year check on the economy, muse on the malaise in the stock market and offer a very contrarian possibility for a positive shock to the world. It should make for a thought-provoking letter.

But first, a very quick three paragraph commercial. In the current market environment, there are managers who have not done well and then there are money managers who have done very well. My partners would be happy to show you some of the managers they have on their platforms that we think are appropriate for the current environment. If you are an accredited investor (basically a net worth over $1.5 million) and would like to look at hedge fund and other alternative fund managers (like commodity traders) I suggest you go to www.accreditedinvestor.ws and sign up and someone from Altegris Investments in La Jolla will call you if you are a US citizen, or from Absolute Return Partners in London if you are in Europe. If you are in South Africa then someone from Plexus Asset Management will call. And for my long-suffering readers who are patiently waiting for another accredited investor letter, there is one in the works. If you sign up today, you will get it. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

If you are not an accredited investor, I work with CMG in Philadelphia. We have created a platform of money managers who specialize in the alternative management space. By this I mean they do not need a bull or bear market in order to have the potential for a profit. (Past performance is not indicative of future results.) You can go to http://www.cmgfunds.net/public/mauldin_questionnaire.asp and quickly read about the recent past performance of a manager we recently added to the platform and signup to get more information.

If you are an investment advisor, all of my partners will work with you to assist you in providing your clients exposure to alternative style investments and managers. Obviously, if your clients are high net worth clients, then you will want to work with Altegris or ARP, and if your clients need lower minimums, then you should work with CMG. And if you have any feedback or comments, feel free to write me. And now, back to our regular letter.

Inflation, Deflation and Stagflation

The quote at the beginning of this letter is from the managing director of the Bank of International Settlements, or the central banker to the central bankers of the world. (Thanks to Simon Hunt for the quote.)

Stagflation is a strong word to use, but Knight is surveying a world that is increasingly looking like it is in trouble. A Morgan Stanley study suggests that 50 countries around the globe have inflation running at 10% or more, and that this represents over 3 billion people.

Almost all of those countries have negative real interest rates, or interest rates that are below inflation (as here in the US). Central bankers around the world are slowly raising rates and tapping on the brakes, but they are going to be under increasing pressure to do so. Thus, Knight suggests that global growth is due to slow down even as inflation is rising.

A quick sidebar. I am often asked what I think about the inflation numbers produced by John Williams of Shadow Government Statistics. His number, using the methodology to figure inflation that existed in the late 70s and early 80s suggest that inflation in the US is over 11%. That certainly corresponds to what many of us feel like as we see food and energy prices rise. If you are bearish, a high inflation number makes your case easier.

But let me make a few of you mad. I think what Williams' number actually do is show that the government did not know how to calculate inflation back then. If inflation were actually 11.8%, then that would mean that GDP was a negative 6% today, and that the US would have been in a recession for several years. That is obviously not the case. You can simply look at corporate profits and tax receipts to see the economy has been growing the past five years.

The recovery after 2003 was in fact robust, and corporate earnings were solid, and tax collections went through the roof after the Bush tax cuts. That is not something that would happen in a high inflation environment.

That being said, let me make two observations. Inflation for much of America is much more than the headline CPI of 4%. If you make $40-60,000 for a family of four, the cost of food, gas, medicine, insurance, etc. is causing the inflation you personally experience to be much more than 5%. The CPI reflects the inflation of all items, but your personal inflation rate depends on what you actually buy. And it seems like a lot of the necessities are running well north of 4% inflation.

Secondly, there are some of the statistical methods used to measure inflation which I think are quite suspect, like hedonic measurements. Just because the computer I buy today is twice as powerful as the one I bought three years ago does not mean that the price of a computer dropped in half. I seem to still spend about the same amount on my new computers or cars. It is still the same percentage of my budget.

If we used the same methodology as Europe (for instance), US inflation would be somewhat higher. And that is a number I would find useful for comparison's sake. But let's get back to main thought.

Louis Gave recently wrote a very interesting essay on inflation. He makes the point I have made often, that the Fed is not really increasing the money supply. If you look at the growth in adjusted monetary base, which is the only measure that the Fed actually can control, it has not been all that much over the past four years. But M2 and other measures of money supply have skyrocketed. What gives?

Two things. One is the extraordinary growth in credit offered by banks around the world. We saw a true inflation in financial assets of all types.

Secondly, and this is less intuitive, the US consumer has been a large supplier of money to the world by running a massive trade deficit. We have seen trillions of dollars flow into the world markets which has to find a home. Those dollars have been part of the growth in the supply of dollars around the world.

Now, let me offer a hypothetical series of events which could alter the current environment and maybe even bring back the specter of deflation.

The US trade deficit is roughly where it has been for four years, running in the neighborhood of 6% of GDP. Only a few years ago, less than 30% of that was for oil. Now, that has changed. Roughly 60% of our trade deficit is spent on oil, much of it sadly going to countries that are not necessarily our friends.

The US consumer has cut his spending on non-oil items by almost 40% in terms of GDP over the past few years, and the trend is clearly down every quarter.

Financial assets are clearly deflating. Banks are cutting leverage as aggressively as they once expanded their balance sheets. Even though the data shows that bank assets (lending) are increasing, it is because they are being forced to take assets that have been off the balance sheet and put them on the balance sheet. That trend in the data is going to reverse, and with a vengeance.

We are also watching home values decline, not just here but in the United Kingdom and soon to be so in a lot of Europe, which will put European banks under even more pressure. That is serious wealth deflation.

I have been pounding the table for over a year that financial stocks are going to continue to show losses for at least through the end of this year. Dividends will be cut. More shares will be sold and further dilution will be a fact for many banks both in the US and in Europe. Trying to pick the bottom in the financial stocks is like catching a falling anvil.

And their distress is going to translate into distress for businesses and individuals who need to borrow money. All of this is deflationary. It is a strange world indeed in which we are in the middle of two bubbles bursting and for inflation to be the headline topic of every financial medium.

The source of the inflation is clear. One is rising food costs. World demand for grain is growing at 1.2% a year, yet yield increases are growing at 1.1% a year. The developed world, both the US and Europe, uses a lot of food for bio-fuels. The major areas where we could increase production are areas like Africa where the infrastructure and production methods are poor.

Everyone now believes that food costs are going to go up, energy will continue to rise and the dollar will continue to fall. And maybe all these trends continue. But let me offer a very contrarian thought or two.

Farmers around the world are going to respond to high food prices and by this time next year we could see a rise in supply that more meets the rise in demand. Prices might begin to actually fall.

Energy prices have risen so much that demand destruction is beginning to happen. US drivers are using less gas, and as Asia takes away its subsidies demand will fall as well. You could see oil prices drop over the next year.

And if oil prices drop, that means the US is shipping less of our dollars offshore, which slows the growth of available dollars, raises the price of the dollar which further lowers the cost of commodities.

In a world of decreased leverage, debt and housing deflation, coupled with lower food and energy costs and a higher dollar, it is possible that inflation drops below 2% by this time next year. Maybe more.

Far-fetched? Maybe. But it is a possibility that few are considering. In the inflationary commodity boom of the 70's, there was a 30% correction, which most don't remember. Everyone was convinced that commodity prices could only go one way. And we do not have the wage pressures and inflation that we did in the 70s.

The cure for high prices is high prices. High prices stimulate production and reduce demand. I see no reason that this could not happen again. Over time, I am along term commodity bull. I think oil could indeed go to $200 or more in the next decade, and as a developing world increases its need for commodities of all types, I see growing demand and prices. But that is then long term.

Stagflation on a world wide basis is going to have an effect on demand in the short term. I would be cautious about long only commodity funds. While I do not expect anything to change abruptly, I would be more vigilant and recognize that trends which look so good now can change. I am not suggesting that you get out, just pay attention to supply and demand figures coming out of the developing world.

Five years ago everyone was worried about deflation. A lot can happen in a short time. Ben Bernanke may be dusting off his helicopter speech in a few years, as deflation once again becomes the concern.

The Slow Motion Recession

Last October 5, I wrote a letter called The Slow Motion Recession. The basic premise then and in this space since then has been that we are either in recession or a lengthy period of very slow growth and that this slow growth will continue for some time. The cause of the lackluster growth is the bursting of the two bubbles of the housing market and the credit crisis. These are not problems that can respond quickly to the Fed cutting interest rates, but will need several years to correct. These deflating bubbles will put pressure on consumer spending and thus on corporate profits.

At the end of the day, it is earnings which drive the price of stocks. And if earnings are under pressure, we are going to see the stock market to continue to be under pressure. In a Slow Motion Recession, with growth depressed in the latter half of this year, it is going to be hard for the stock market to gain any real traction. As I have been writing for some time, in a recession the US stock market typically falls 30% or more. We are now down almost 20%. It would not be surprising to see the markets fall another 10%, at least from the perspective of history.

And inflation is not helping. Inflation is often more damaging to stock prices than a slow economy. Inflation, especially in a slow growth economy, eats into profits and can be hard to pass on to customers who are under spending pressure. And while inflation may slowly go away over the next year, it could be a factor for the remainder of the year.

While we should see some rallies in July and August, I think the trend is going to be lower, as the earnings projections are going to come down, and guidance is likely to be soft for many companies.

A Slow Motion Recession, a Muddle Through Economy, and inflationary pressures are not a prescription for a robust bull market. Further giving cause for concern, the recent rise in consumer spending is largely attributable to the stimulus checks being spent. This will be largely over by the middle of the next quarter. As gas and food prices eat into more and more of the average US consumer's ability to spend money on other discretionary items, there will be pressure on almost any company that has exposure to the US consumer.

An Update on Myanmar

My good friend Ed Artis and a team of workers are currently in Myanmar helping the victims of the recent hurricane. His stories are heart- wrenching. My readers have been very generous in helping provide relief. They are one of the few teams that have been able to get in and direct help to exactly where it is needed.

They are working to help re-establish an orphanage, help farmers, supply needed food and medicine to families. The need is overwhelming. He is going to stay a while longer and asked me to ask you, gentle reader, if you could send a donation to help purchase more supplies. The need for food for families is large.

One of the real needs is for more water buffalo. They cost about $500, but allow a farmer to feed his family and more. And it is not as easy buying a buffalo as it looks. Ed tells me that many are in shock. Many of the ones that did not die will not work because they are scared silly. "I never considered that as a possible problem but it is BIG TIME," he writes. "Buffalo with Post Traumatic Stress Disorder just stand there and stare into space."

Donations made thru Pay Pal with a credit card are best as they get quicker access to funds. Go to www.kbi.org and scroll down till you find the donate button. Click on it and it takes you to Pay Pal. "We can also accept checks made out to Knightsbridge International, PO Box 4394, West Hills, CA 91308-4394, they just take longer to get funding to us here in the field."

These are the good guys. They are there on their own nickel. Not a penny goes to overhead or salaries. I cannot say too much about them. I can personally vouch for them. They are a small operation, but their efforts are very large. They get in where other groups just can't. Pony up some money for a buffalo.

Eileen, being the better businesswoman, then suggests to Ethel that they sell tickets that promise to deliver a pie later that day. This will shorten the line and limit the number of people standing and waiting for their pies to be finished. The line indeed gets much shorter as Eileen sells the tickets and Ethel feverishly cranks out more and more pies. Ethel and Eileen are making plenty of money and everyone is happy. Well, except bitter Betty at the bratwurst stand who complains to the fair chairman of “excessive profits”.

Now Jacob runs the tilt-a-whirl and notices how many pies Ethel and Eileen are selling. He hears someone say, “Her pies are so good I would pay $10 for another.” Jacob gets an idea to buy the tickets and resell them later, at dinnertime, for a higher price. He’s going to speculate on the price of pies. He heads over to Ethel’s booth and starts buying up pie tickets. A little later, he starts selling them for $7, then $8, and then $10.

Other ride operators notice what Jacob is doing, so they get in on the gig as well, knowing that soon Ethel can’t possibly promise too many more pies. They start buying up the remaining tickets. Of course, Eileen is no fool. She raises the prices to $12, to $15, to $20, and all the way up to $25. The speculators keep buying the tickets, pouring more and more money into the apple pie market at the county fair.

There is a problem here. What will happen if no one wants to buy the pies later for $25? What if no one is willing to pay even $10 for a pie? The pies are coming whether the speculators can sell them or not. People attending the fair have to buy the pies from the speculators or the speculators will be left holding a bunch of pies that nobody wants. Unless the speculators are complete idiots, they know this too. The price can crash, as well as the value of their investment, because they may have paid Ethel to produce way too many pies.

Imagining that ride operators at the county fair are not so wise may not be difficult, but to suggest that Wall Street analysts would be so foolish and not realize that this was possible is a stretch. If they bid up the price of oil much higher than refineries are willing to pay they will likely face catastrophic losses.

Even if they are this foolish, this is good for the consumer in the long run. The price will eventually crash and oil will be cheaper than ever before. When prices are high, oil companies spend more and more money building oil rigs and pipelines, and they will find more and more oil. They are just like Ethel, churning out more and more pies. If the price plummets this new capacity doesn’t go away, because the costs are sunk costs. There will be a huge glut of oil for a long time. If the speculators are really driving up the price of oil, our current pain will soon be alleviated with years of cheap gasoline.

Leave the speculators alone. If they are right, they will make money. If they are wrong, they will lose money. Either way it doesn’t change what we have to pay at the pump. Just because Jacob foolishly bought a pie for $25, doesn’t mean that visitors to the fair will pay $25. Just because Jacob and the speculators paid Ethel to bake 500 pies, doesn’t mean people want to eat 500 pies. When a speculator pays $140 a barrel for oil months in advance, it doesn’t mean that refiners will be willing to pay $140 when that oil arrives. When speculators pay drillers to pump a trillion barrels of oil, it doesn’t mean that we will want a trillion barrels of oil. Supply and demand still rules the retail market.

A new global growth strategy is needed to maintain global economic progress. The basic issue is that the world economy is now so large that it is hitting against limits never before experienced. There are 6.7 billion people, and the population continues to rise by around 75 million per year, notably in the world’s poorest countries. Annual output per person, adjusted for price levels in different parts of the world, averages around $10,000, implying total output of around $67 trillion.

There is, of course, an enormous gap between rich countries, at roughly $40,000 per person, and the poorest, at $1,000 per person or less. But many poor countries, most famously China and India, have achieved extraordinary economic growth in recent years by harnessing cutting-edge technologies. As a result, the world economy has been growing at around 5% per year in recent years. At that rate, the world economy would double in size in 14 years.

This is possible, however, only if the key growth inputs remain in ample supply, and if human-made climate change is counteracted. If the supply of vital inputs is constrained or the climate destabilized, prices will rise sharply, industrial production and consumer spending will fall, and world economic growth will slow, perhaps sharply.

Many free-market ideologues ridicule the idea that natural resource constraints will now cause a significant slowdown in global growth. They say that fears of “running out of resources,” notably food and energy, have been with us for 200 years, and we never succumbed. Indeed, output has continued to rise much faster than population.

This view has some truth. Better technologies have allowed the world economy to continue to grow despite tough resource constraints in the past. But simplistic free-market optimism is misplaced for at least four reasons.

First, history has already shown how resource constraints can hinder global economic growth. After the upward jump in energy prices in 1973, annual global growth fell from roughly 5% between 1960 and 1973 to around 3% between 1973 and 1989.

Second, the world economy is vastly larger than in the past, so that demand for key commodities and energy inputs is also vastly larger.

Third, we have already used up many of the low-cost options that were once available. Low-cost oil is rapidly being depleted. The same is true for ground water. Land is also increasingly scarce.

Finally, our past technological triumphs did not actually conserve natural resources, but instead enabled humanity to mine and use these resources at a lower overall cost, thereby hastening their depletion.

Looking ahead, the world economy will need to introduce alternative technologies that conserve energy, water, and land, or that enable us to use new forms of renewable energy (such as solar and wind power) at much lower cost than today. Many such technologies exist, and even better technologies can be developed. One key problem is that the alternative technologies are often more expensive than the resource-depleting technologies now in use.

For example, farmers around the world could reduce their water use dramatically by switching from conventional irrigation to drip irrigation, which uses a series of tubes to deliver water directly to each plant while preserving or raising crop yields. Yet the investment in drip irrigation is generally more expensive than less-efficient irrigation methods. Poor farmers may lack the capital to invest in it, or may lack the incentive to do so if water is taken directly from publicly available sources or if the government is subsidizing its use.

Similar examples abound. With greater investments, it will be possible to raise farm yields, lower energy use to heat and cool buildings, achieve greater fuel efficiency for cars, and more. With new investments in research and development, still further improvements in technologies can be achieved. Yet investments in new resource-saving technologies are not being made at a sufficient scale, because market signals don’t give the right incentives, and because governments are not yet cooperating adequately to develop and spread their use.

If we continue on our current course – leaving fate to the markets, and leaving governments to compete with each other over scarce oil and food – global growth will slow under the pressures of resource constraints. But if the world cooperates on the research, development, demonstration, and diffusion of resource-saving technologies and renewable energy sources, we will be able to continue to achieve rapid economic progress.

A good place to start would be the climate-change negotiations, now underway. The rich world should commit to financing a massive program of technology development – renewable energy, fuel-efficient cars, and green buildings – and to a program of technology transfer to developing countries. Such a commitment would also give crucial confidence to poor countries that climate-change control will not become a barrier to long-term economic development.

Jeffrey Sachs is Professor of Economics and Director of the Earth Institute at Columbia University.